Global
A Tale of Two Asias
May 22, 2006

Stephen S. Roach (New York)

The China-India comparison is central to the Asia debate.  It is also of great importance to the rest of the world.  In the end, it may not be either/or.  While the Chinese economy has outperformed India by a wide margin over the past 15 years, there are no guarantees that past performance is indicative of what lies ahead.  Each of these dynamic economies is now at a critical juncture in its development challenge — facing the choice of whether to stay the course or alter the strategy.  The outcome of these choices has profound implications — not just for the 40% of the world’s population residing in China and India, but also for future of Asia and the broader global economy.

As recently as 1991, China and India stood at similar levels of economic development.  Today, the Chinese standard of living is over twice that of India’s, with China’s GDP per capita hitting US$1,700 in 2005 versus a little over $700 in India.  The two nations have approached the development challenge in very different ways.  For China, it’s been a manufacturing-led growth strategy, whereas for India, it has been much more of a services-based development model.   While each approach has its advantages and disadvantages, China’s outstanding performance in the development sweepstakes over the last 15 years makes it a very tempting model for the rest of Asia to emulate. 

The contrast between the two approaches is dramatic.  The industry share of Chinese GDP has gone from 42% to 47% over the past 15 years — maintaining a huge gap over India’s generally stagnant 28% manufacturing portion over the same period.  By contrast, the services share of Indian GDP has risen from 41% in 1990 to 54% in 2005 — well in excess of the lagging performance in Chinese services, which has gone from 31% of GDP in 1990 to 40% in 2005.  China’s macro character fits its manufacturing-led growth dynamic to a tee.  Benefiting from a high domestic saving rate, huge inflows of foreign direct investment (FDI), and major efforts on the infrastructure front, Chinese economic growth has been increasingly fuelled by exports and fixed investment.  Collectively, these two sectors now account for over 75% of China’s GDP — and are still growing at close to a 30% rate today. 

India’s macro story is the mirror image of China’s in many key respects.  Constrained by a lower saving rate, limited inflows of FDI, and a sorely neglected infrastructure, India has turned to a fragmented services sector as the sustenance of economic growth.  The labour-intensive character of services has provided support to India’s newly emerging middle class — a key building block for India’s consumption-led recovery.  As a result, private consumption currently accounts for 61% of Indian GDP — far outstripping the 40% share in China.  The growth contribution of India’s export and investment sectors pales in comparison to that in China.

Interestingly enough, as both of developing Asia’s largest economies look to the future, they do so with an eye toward emulating the other.  China is now very focused on a rebalancing of its growth dynamic — moving away from exports and investment more toward an Indian-style consumer-led model.  This is more by necessity than choice.  A continuation of the export surge is a recipe for protectionism, while pushing an already excessive investment binge risks capacity overhangs and deflation.  At the same time, China also aspires to match India’s progress on reforms.  India currently has over 25 world-class companies, well-developed capital markets, a modern banking system, and a deeply entrenched rule of law.  China is lacking in all of those key respects, and very much wants to move in those directions.  China is also seeking to implement an Indian-style expansion of labour-intensive services in an effort to provide job and income support to its nascent consumer sector.  However, given the high degree of precautionary saving sparked by massive layoffs arising from state-owned enterprise reforms, China may well encounter considerable difficulty in establishing a broad-based consumer culture. 

At the same time, India very much aspires to match China’s progress on the manufacturing front.  India’s political leadership is convinced that manufacturing is the answer to high unemployment in impoverished rural areas.  Whenever I go to India, I always have the same debate with its politicians and policy makers.  I take the side that the inherent labour-saving bias of capital-intensive global manufacturing platforms promises little hope for Indian employment.  I have seen this first-hand on my visits to Indian manufacturing companies — factory floors more heavily populated by robots than by human workers.

India’s leaders have a very different vision of manufacturing.  They have seen what China can do and genuinely hope to achieve a similar outcome.  Earlier this year, at the World Economic Forum in Davos, I pressed senior Indian officials on the specifics of this strategy — asking them to identify the potential sources of manufacturing-led job creation.  Their answer — food, textiles, and leather — potentially high-volume industries that could well offer gainful employment opportunities to relatively poor, under-educated, young rural workers.  By contrast, unlike the Chinese, the Indian leadership is not all that enamoured of the job-creating potential of labour-intensive services.  In particular, they point out that IT-enabled services — the crown jewel of India’s “new economy” — mainly offers employment to the elite graduates of India’s prestigious institutions of higher education. 

What comes out of this debate is that both China and India are at important inflection points in their development experiences.  They both are very focused on broadening out their bases of economic support.  China wants to push more into services and establish a consumption-based growth dynamic.  India wants to enlarge its manufacturing footprint by putting greater emphasis on infrastructure and FDI.  In both cases, the growth objectives are focused on solving a very difficult rural unemployment and poverty problem.  Moreover, in China’s case, there is the added complication of its daunting ownership transition from a state- to a privately-owned economy. 

All this is not without rising political tensions.  Reflecting understandable concerns over social stability that have arisen in both China and India, the interplay between politics and economics is clearly having an important influence on the execution of their respective “broadening out” strategies.  There are equally profound questions for the rest of the world: If India is to services as China is to manufacturing, what role does that leave for the high-cost developed world?  Down the road, if India also succeeds in pushing into manufacturing while China makes successful forays into services, the same question becomes all the more challenging to the world’s major industrial economies.  Protectionism is the biggest risk in all this.  IT-enabled globalization is pushing economic development into both manufacturing and services at a breakneck pace.  Moreover, IT-enabled connectivity has increasingly transformed once non-tradable services into tradables — and has moved rapidly up the value chain and occupational hierarchy in doing so.  The result is a mounting sense of economic insecurity in the developed world that has become a lightning rod for political action that, unfortunately, has been manifested in the form of an increasingly worrisome protectionist backlash. 

This is not the experience that orthodox economics understands.  The win-win theory of globalization — workers in poor countries getting rich through trade but then turning around and buying things made by rich countries — just isn’t working.  That’s because both the speed and scope of an IT-enabled globalization has broken the mould of the classic theory of comparative advantage.  In days of yore, it was fine — albeit painful — for rich countries to give up market share in tradable manufactured products.  That’s because highly-educated knowledge workers could seek refuge and shelter in nontradeable services.  However, with nontradables becoming tradable and with educational attainment and skillsets rising rapidly in the developing world, the security of the old way no longer exists.  Sadly, that provides both the justification and the opening for protectionists.

China and India represent the future of Asia — and quite possibly the future for the global economy.  Yet both economies now need to fine-tune their development strategies by expanding their economic power bases.  If these mid-course corrections are well executed — and there is good reason to believe that will be the case — China and India should play an increasingly powerful role in driving the global growth dynamic for years to come.  With that role, however, comes equally important consequences.  IT-enabled globalization has introduced an unexpected complication into the process — a time compression of economic development that has caught the rich industrial world by surprise.  Out of that surprise comes a heightened sense of economic security that has stoked an increasingly dangerous protectionist backlash.  This could well pose yet another major challenge to China and India — learning how to live with the consequences of their successes.

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U.S.A.
The Risk-Reduction Trade
May 22, 2006

Richard Berner (New York)

Fear that the Fed may have been lax on inflation and will now have to trample on the economy to crush accelerating prices has unleashed a significant risk-reduction trade in global financial markets.  The selloff in risky asset markets has been global, with previously soaring emerging Asian and Latin American equity markets and commodities selling off the hardest last week — between 5-10% for equity markets and 8-15% in some key base and precious metals like copper, aluminum, zinc, silver and gold.  The cost of corporate default protection has risen slightly and equity volatility measured by the VIX jumped by about 5 points (40%) to a 12-month high. 

The flight to safety has resulted in a significant bull-flattening rally in Treasuries, with 10-year yields tumbling by more than 10 basis points over the past week, and 10-year breakeven inflation in the TIPS market narrowing by a similar amount.  In addition, the Treasury and eurodollar yield curves are moving back toward “conundrum” territory, with the Fed funds futures market now pricing in about a 60% chance of a 25 bp rate hike at the June 28-29 FOMC meeting and longer-maturity yields all below that future level.  In other words, the bond market has, in the words of my colleague Ted Wieseman, “flipped from inflation scare to growth scare,” thinking that the next Fed tightening move will be a mistake that will quickly be unwound.  In contrast, we continue to think that the Fed has more work to do, and with yields at the lower end of a neutral range, we’re mildly bearish on bonds.  Investors should sell into bond-market rallies and look for better buying opportunities at levels for 10-year yields between 5¼% and 5½%.

In my view, the correction in previously-soaring risky asset markets is hardly surprising; after all, until recently many investors were hoping for the Goldilocks scenario of just enough growth to sustain earnings, credit quality, and brisk demand for commodities, but not enough to stir inflation and more Fed tightening.  And Morgan Stanley’s strategists have been nothing if not vocal in urging investors to take a more defensive stance in their portfolios — a move that our fundamental analysis supported.  However, some believe that Mr. Market was beginning to sniff out a scenario reminiscent of 1987, with rising inflation risks, a falling dollar, and Fed officials seemingly more concerned about downside risks to growth than upside risks to inflation — in short, that the market’s problems stem partly from a Fed whose inflation-fighting bona fides under a new Chairman had yet to be tested and which might be “behind the curve.” 

As I see it, one can hardly argue that this Fed has slipped behind the curve, having just raised the funds rate by 400 basis points in less than two years to a level that some officials believe is mildly restrictive, with core inflation slightly above the upper end of the Fed’s presumed comfort zone of 1-2%, and while affirming that “some further policy firming may yet be needed to address inflation risks.” 

But the Fed does face two key challenges: First, how to complete the transition from a stimulative monetary policy to one that adapts to changes in the outlook for inflation and growth — changes that in my view will show that the Fed’s forecast is a little too optimistic about inflation and a little too pessimistic about growth.  And second, how to articulate clearly the nuances of the current strategy and tactics while weaning investors from the relatively explicit policy guidance that officials agree has outlived its usefulness. 

Meeting the first challenge is straightforward; after all, monetary policy has always involved making forecasts and adapting policy to the shifting risks in the outlook.  The Fed’s risk management policy philosophy involves balancing those risks where they conflict or create crosscurrents.  In that context, market concerns that Fed officials could overdo tightening are overblown.  Despite past increases in inflation, prospective developments may yet allow them to pause in June.  Officials are acutely aware that the effects of past tightening moves are not fully evident in credit-sensitive sectors like housing.  While first-quarter growth likely accelerated to a 6% clip, the second quarter likely slowed to half that pace, and could represent the transition to a below-trend growth path. 

At the same time, officials aren’t likely to let inflation rise significantly.  To be sure, they believe that the current inflation uptick is transitory, and the cooling in future inflation expectations and tighter financial conditions will reassure them that they can take stock of what they have accomplished.  Five year, five year forward breakeven inflation rates have receded by 12 bp during the past week, and the University of Michigan’s consumer surveys indicated that 5-10 year inflation expectations were slightly elevated but stable at 3.1% in early May.  But the Fed’s actions to date suggest no lack of anti-inflation resolve in the context of underlying inflation that, while drifting up, is still low. 

Meeting the second challenge — articulating the game plan — is more difficult because it is more uncertain.  Two details illustrate the point.  First, to increase policy transparency, the Fed is beginning to provide more details about their baseline forecast, which helps frame the policy debate and assists market participants in thinking about the path of monetary policy.  More details don’t mean that the forecast is any more certain than in the past, however, so I expect that the minutes of the May 10 FOMC meeting will provide a richer discussion both of risks to the outlook and of the possible policy responses to them.  Second, officials want to provide some sense of policy tactics to condition market expectations, but exactly how much to provide is still an evolving art.  For example, the notion that the Fed might pause “even if in the Committee's judgment the risks to its objectives are not entirely balanced” is not unreasonable if analysis strongly suggests that the current uptick in inflation is temporary.  But in the context of rising inflation expectations, stating it may have stirred the concerns about the Fed’s anti-inflation resolve.

The Fed’s resolve is a key issue for many market participants who believe that a combination of rising inflation and slower growth creates a delicate balancing act for monetary policy, and that the resteepening of the yield curve has reflected concerns about the Fed’s inflation-fighting credibility.  In my view, any such concerns will be short-lived: Much of the yield curve move this year has reflected a rise in real yields and term premiums.  And I think that a resumption of resilient growth in the summer will end the Fed’s perceived dilemma.  Until that resilience resurfaces, however, investors may continue to reduce risk in their portfolios.

The risks from my perspective are two-sided.  For one, investors may soon grapple with a whiff of stagflation: The cyclical forces driving inflation higher could last longer and push inflation a tick higher than we anticipate.  And the spring growth slowdown could be a little more evident.  Supply-induced energy price hikes would magnify those risks.  If anything, however, it appears that energy prices are peaking at levels lower than we expected a month ago, and I think that stronger-than-expected growth remains the bigger risk.

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U.S.A.
Review and Preview
May 22, 2006

Ted Wieseman (New York) and David Greenlaw (New York)

The Treasury curve saw a major bull flattening rally over the past week, as the market – at least taking the price action at face value, and it is far from clear at this point how much of what happened was fundamental and how much was flight to quality, short covering, or otherwise flow driven – suddenly flipped from inflation scare to growth scare. The seemingly unlikely main trigger for the reversal, which along with the return of the “conundrum” to the Treasury curve was accompanied by a big shift in medium-term Fed pricing, was a second straight upside surprise in core CPI and subsequent comments from Richmond Fed President Lacker that the deteriorating inflation picture made a pause at the June FOMC meeting less likely. The futures market correspondingly sharply upped the odds of a June rate hike but decided that such a move would be a mistake, quashing both inflation and the economy and necessitating a quick reversal from the Fed, with the eurodollar futures curve after September moving back into significant inversion, after having finally nearly full disinverted at the end of the prior week, and TIPS breakeven inflation spreads falling significantly. After the market’s previous fixation on housing market risks had been largely set aside for a while in favor of inflation worries, the sharp fall in housing starts contributed to the return of growth pessimism in the latest week.

Clearly, however, a flight to safety from weakness in stocks and commodity prices and fears of what these declines might portend for the economy also were a key driver of bonds as well, and this boost caught a bearish market offsides and forced some significant short covering as well as reversal of curve steepening trades.

Over the past week benchmark Treasury yields fell 4 to 16 bp, with 2’s-30’s plunging 12 bp on a 16 bp drop in the long bond yield to 5.14%, the low in nearly a month, and a 4 bp decline in the 2-year yield to 4.96%. The 10-year yield fell 13 bp to 5.05%, the 5-year 11 bp to 4.96%, and the 3-year 7 bp to 4.95%. Through Wednesday, the curve had been seeing a modest bull steepener, as flight to safety from weak stock and commodity markets boosted the front end relatively, but the longer end caught fire Thursday and Friday, with the 30-year yield plunging 15 bp in two days for no obvious fundamental reason. Even with the underperformance of the front end, note that the 2-year, along with the 3-year and 5-year, has now moved into a sustained inversion to the funds target for the first time in the cycle. And the inversion is even starker considering where the funds target is priced to be in just six weeks, with the July fed funds contract selling off 5 bp on the week to 5.155%, a new contract high rate that prices about a 60% chance of a 25 bp rate hike at the June 28-29 FOMC meeting.

But the market has now suddenly decided again that the expected move to 5.25% – which if not in June is fully priced to come shortly thereafter with potentially more to follow, as the October fed funds contract lost 4.5 bp to 5.265% – will be a policy error necessitating a quick reversal. This was seen in moves back into inversion in the 2’s-3’s curve and in an associated reinversion of the eurodollar futures curve, which had finally moved nearly fully out of inversion at the close of the prior week. This was short lived, as the Sep 06 to Sep 07 spread plunged 12 bp on the week to -10 bp, with the former selling off 3.5 bp to 5.365% and the latter rallying 8.5 bp to 5.265%. The Dec 06 to Dec 07 spread saw a similar move, falling 9.5 bp to -9.5 bp. Not only will further Fed rate hikes quash the economy, but they will also get inflation back under control according to the market, as we had the odd spectacle of two of the worst back-to-back CPI reports in many year resulting in a major compression in TIPS breakeven inflation spreads.

The benchmark 10-year spread plunged 10 bp to 2.62%, the lowest weekly close in five weeks, while the Fed’s preferred market based measure of inflation expectations, the 5-year/5-year forward TIPS breakeven inflation rate, dropped 11 bp after hitting a recent peak at the end of the prior week.

Obviously, however, with the turmoil in other markets seen through the week, it remains quite uncertain to what degree these moves in Treasuries and interest rate futures prices actually meant anything fundamental. Certainly there was a flight to safety bid in the market through the week as the S&P 500 fell 2% (which was actually a relatively strong performance compared to the much larger drubbings many other markets took, especially in Europe and various emerging markets) and bubbly commodity prices appeared to be in some trouble. The June crude oil contract fell $3.50 a barrel on the week (-5%) to $68.53, a six-week low, while July copper plunged $0.40 a pound (-10%) to $3.46. The flight to safety bid this helped engender in Treasuries clearly seemed to catch the previously bearish market badly out of position, forcing a lot of short covering and stop outs of curve steepening trades. So it remains to be seen going forward to what degree there has been a fundamental change in bond market sentiment and to what degree we’ve just seen a temporary flow-driven shake out.

Economic data the past week showed worsening inflation combined with mixed signs on growth – housing market weakness, but strength in industrial activity (including rising inflation risks from increased “resource utilization” in the factory sector), along with generally solid leading indicators for the upcoming employment and ISM reports.

The consumer price index jumped 0.6% in April for a 3.5% Y/Y gain, as energy prices surged 3.9%, with a 12% gain in gasoline offsetting a 1.5% drop in utilities. The core index rose an above-trend 0.3% for a second straight month – the worst back-to-back readings in a more than a decade – lifting the year/year rate to +2.3% from +2.1%. Upside in the core was spread across a number of categories, including the key owners’ equivalent rent component (+0.4%), rent (+0.3%), apparel (+0.6%), airfares (+1.6%), and medical (+0.4%). Tightening rental markets have led to a recent pickup in both rent and OER, with the latter also having recently started to catch up to the former as utility costs have fallen, leading to relative upside in the ex utilities “pure rent” calculation used to convert rent to OER. We expect the core CPI upside to be reflected in the upcoming core PCE reading, where we also look for a 0.3% gain. Depending on rounding, this would lift the year/year rate to

+2.1% or +2.2%, breaking through the top of the Fed’s 1% to 2% “comfort zone.” Clearly such a move would be unwelcome to Fed officials and raise the odds of a June rate hike. But FOMC members have also generally explained that they will not be terribly alarmed by what they expect might be some temporary upside in core inflation reflecting pass-through of prior energy price gains as long as growth appears to be slowing to trend and inflation expectations remain contained. So the growth numbers in the coming week as well as measures of inflation expectations, including Friday’s University of Michigan survey, will be key to watch in trying to judge the Fed’s response to deteriorating inflation data.

Unlike the Fed, we do not think that the recent upside in inflation will prove so temporary, though the +3.0% year-to-date annualized jump in the core CPI probably overstates the underlying trend. In our view, rising inflation expectations, dwindling (or perhaps nonexistent) slack in product and labor markets, the weakening dollar, and rising labor and materials costs combined with what we expect will be a more robust second half demand backdrop (domestic and continued global upside) following a temporary Q2 slowdown, point to a further move higher in core inflation going forward. We continue to look for core CPI to rise to +2.7% and core PCE to +2.5% by year-end, bringing in more Fed rate hikes eventually, even if there is a pause in June (which in our view remains a close call at this point).

We finally started to see some indications pointing to the expected second quarter pause, after what we expect will be a revised 6.0% surge in Q1 GDP, in the latest week’s data. Overall, though, the data were certainly not all that weak, with the softness continuing to be mostly confined to housing at this point. On that front, housing starts fell 7.4% in April to 1.849 million units annualized, the lowest level since November 2004. Since a warm weather induced spike in January, starts have now fallen three straight months for a cumulative 18% drop. This sharp correction has come against the backdrop of a big rise in inventories of unsold new homes in recent months. Single-family starts fell 5.6% in April to 1.535 million, while the more volatile multi-family category declined 15.1% to 314,000. Regionally, the downside was in the two largest regions, the South (-16.0%) and the West (-9.7%). Starts in the South had been holding up surprisingly well until this latest decline, while housing activity in the West appears to be slowing notably in response to near record low affordability. If the market has indeed shifted its focus from inflation back to housing as the key data, then more supportive numbers are likely in the coming week, as we look for downside in new and existing home sales after the surprisingly strong March outcomes (particularly for the former).

In addition to slowing housing, while there hasn’t been much of any hard data at this point, early indications continued to point to an ongoing hit to consumer spending from the recent spike in energy prices. The weekly ABC News/Washington Post consumer comfort index remained in freefall, dropping another point in the latest four-week period to -17, the fourth straight drop for a cumulative 10-point fall to the lowest level since the aftermath of Katrina. The weekly chain store reports have been tracking a bit soft so far this month, though now that Wal-Mart has stopped its weekly sales updates, it is unclear how much value these reports still have. And there have been some early anecdotal rumblings of significant weakness in May auto sales, though probably not much useful can be said on that score until we get through the key Memorial Day weekend selling period. Still, taking on board some of the more negative early indications for the consumer, on a preliminary basis we’ve cut our estimate of Q2 GDP to +3.0% from +3.5%. We’ll firm up this estimate once the details of the Q1 revision have been released.

On the other hand, the industrial sector still seems to be doing quite well, and the labor market appears to be holding up very solidly.

Clearly the factory sector was quite robust in April, as industrial production surged 0.8%, with utility and mining output each up 0.9% and the key manufacturing gauge gaining 0.7%. The manufacturing gain was restrained by a 1.1% pullback in motor vehicle output. The motor vehicle sector looks set to subtract several tenths from Q2 growth after knocking 0.4pp off Q1. Excluding motor vehicles, factory production gained a broadly based 0.9%, led by machinery, electrical equipment, aircraft, primary metals, food, and chemicals. The overall capacity rate rose to 81.9% from 81.4% and the manufacturing rate to 80.8% from 80.4%, both highs since mid-2000. The manufacturing rate has now risen 8.8 percentage points from the late 2001 trough to stand 1.3pp above the long-term average. Early indications for May released the past week were mixed, as the normally well correlated Empire State and Philly Fed surveys diverged significantly. An ISM-weighted and rebased composite of the key activity gauges (which we find much more useful to look at than the more volatile headline sentiment readings in these surveys) showed the Empire State rising to 56.1 from 55.8 while the Philly Fed dropped to 52.5 from 55.6. Taking these two surveys into consideration as well as the uptick in the Morgan Stanley Business Conditions Index, we look for the May ISM to dip 1.3 points to a still strong 56.0.

Meanwhile, while the continued fallout from the budget impasse that led to a temporary shutdown of the Puerto Rican government again sharply boosted initial jobless claims in the latest week, the numbers were much better when this distortion was stripped out. Excluding Puerto Rico, the Labor Department said that claims would have come in at 312,000 in the latest week (which was the survey week for the May employment report), up from an ex-Puerto Rico number of 299,000 the week before. Continuing claims also continued to portray a robust underlying job picture, rising 8,000 in the week of May 6 to 2.389 million, just off the cycle low hit the prior week. Puerto Rico is not included in the monthly jobs tally, so the distortions to claims the past couple weeks will not impact the employment report. Based on the solid recent underlying claims results, our preliminary forecast is for a 200,000 gain in May nonfarm payrolls.

We also expect the unemployment rate to drop to another new cycle low of 4.6%.

There are a number of notable economic data releases out in the coming week, but the next key round of numbers will be after Memorial Day when we’ll get employment, ISM, and auto and chain store sales for May. On the supply front, Treasury will announce a 2-year and 5-year Monday for auction Wednesday and Thursday. We look for unchanged $22 billion and

$14 billion sizes. Generally speaking, the supply backdrop looks increasingly positive as the budget numbers are looking better by the day. We now estimate that Treasury will pay down $91 billion in Q2, up a whopping $40 billion from the $51 billion estimate announced May 1.

Indeed, given the ongoing surge in tax revenues, our recently reduced

$325 billion FY2006 budget deficit estimate is starting to look very conservative. Key data releases due out in the coming week include durable goods and new home sales Wednesday, revised GDP and existing home sales Thursday, and personal income and spending and University of Michigan consumer confidence Friday:

* We look for a 1.2% gain in April durable goods orders. Company data point to a further climb in the volatile aircraft component during April. This swing accounts for all of the expected gain in overall bookings. Indeed, the key nondefense capital goods ex aircraft category is expected to be flat on the heels of the +3.4% spike seen in March.

* We forecast a drop in April new home sales to a 1.10 million unit annual rate. The recent deterioration in the homebuilder sentiment survey points to some moderation in sales of newly constructed residences. So, after a sharp jump in March, we look for about a 10% drop in April.

* We look for a sizeable upward revision to Q1 GDP to +6.0% from the initial estimate of +4.8%. The bulk of the expected adjustment should be in the inventory and foreign trade components. However, final domestic demand growth should be revised up to a very robust +6.3% (from +5.9%), with higher readings expected in the construction, consumption, and capital spending components.

* The recent slippage in the NAR’s pending home sales index points to about a 2.5% dip in April existing home sales to a 6.75 million unit annual rate following some surprisingly elevated readings in February and March.

* We forecast a 0.8% gain in April personal income and a 0.7% rise in spending. Although payroll employment growth in April was sub par, a sharp jump in average hourly earnings and an uptick in the length of the workweek point to a sizeable gain in wages and salaries. Also, rising government outlays for the new Medicare prescription drug program should lead to a further climb in transfer payments. On the spending side, a solid 1% jump in retail control – much of which admittedly was tied to a price-related jump in the gas station category – points to a rise in overall consumption that is nearly identical to the expected advance in income. Finally, the core PCE price index is expected to match the 0.3% rise in core CPI with the year/year ticking up to +2.1% or +2.2% depending on rounding (it was +2.0% in March).

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Global
A Transatlantic Inflation Divide?
May 22, 2006

Elga Bartsch (London)

During the past week, we received April inflation reports for both the euro area and the US. Both showed a two-tenths rise in the year-over-year core inflation rate.  But what a different market reaction they got!  In the euro area, core inflation rose from 1.3%Y to 1.5%Y, while in the US it climbed from 2.1%Y to 2.3%Y.  In both cases, the reported data were slightly ahead of what the market consensus and we had expected.  We believe that there is more upward pressure on core inflation to come on both sides of the Atlantic, though, and forecast euro area core inflation to converge with headline inflation and breach 2% in January 2007, when a three-point VAT hike in Germany kicks in.  Similarly, my US colleagues, Dick Berner and Dave Greenlaw, project US core inflation to rise to 2.7%Y later this year and expect the core PCE deflator to break out of the Federal Reserve’s comfort zone of 1-2% over the same time period (see Pause Or Not — The Fed Has More Work to Do, May 12, 2006).

A number of statistical quirks are worth keeping in mind, we think.  In the euro area, a number of core components, notably recreation and some of the travel and tourism-related categories, seem to have been affected by the timing of Easter.  In terms of the year-over-year inflation rate, these effects should start to unwind in May, thus helping to contain the upward pressure from the pass-through of higher energy prices.  In the US, our experts point out that airfares have been soaring all year, while hotel rates were actually surprisingly low in April.  In their view, hotel prices remain considerably below where they should be compared to industry data, suggesting that they should see some big upside going forward.  Another important factor behind the rise in the US April core CPI was a further sharp increase in owner-equivalent rents.  This rise, which reverses a trend observed last year, was in part driven by falling utility bills stateside, which tends to boost the estimate of owner-equivalent rents.  The reversal of this distortion has room to run further, according to my colleague Ted Wieseman.  In addition, he foresees a further rise in rents given the significant tightening in the US rental market.  Naturally, this effect wasn’t present in the euro area HICP.  This is due to the simple fact that the HICP does not include any estimates of the costs of owner-occupied housing.  The lack of owner-occupied housing in the European HICP figures constitutes a major methodological difference between the US CPI and the EMU HICP. We estimate that an inclusion of owner-occupied housing in the HICP, which is something European statisticians are working on at the moment, could lift the average inflation rate in the euro area by up to 0.6 percentage points (see EuroTower Insights: Lifted by House Prices, August 4, 2005). Taking into account these reports, the money market is now assigning a 50:50 probability to another 25bp rate hike at the Federal Reserve’s end-June meeting.  Previously, the market was, on balance, expecting the Fed to pause at that meeting.  In the euro area, the market is fully priced for a 25bp rate hike at the ECB’s early June meeting. However, despite a number of ECB Council members explicitly leaving the door open regarding the size of the move, the market remains dismissive of the idea of a larger 50bp rate hike at that meeting.  Instead, the market is pricing in another 25bp move by the ECB by the end of August. 

Similarly, breakeven inflation rates embedded in the index-linked bond market have risen considerably more in the US than in Europe.  While US breakeven inflation rates have increased by some 45bp since the beginning of the year, their Euroland counterparts have climbed less than 25bp over the same time period.  This picture, however, changes somewhat if we take into account that US breakeven inflation rates have historically been considerably more volatile than euro area ones.  This could partially reflect the fact that the US CPI-U index is more volatile than the HICP ex-tobacco.  In addition, the fact that the Federal Reserve, contrary to the ECB, has no publicly announced inflation objective might make it more difficult to anchor inflation expectations in the US.  Adjusting for the historical volatility, the rise in breakeven inflation is equivalent to roughly one standard deviation in both cases.  Hence, markets might actually be testing the resolve of both major central banks as inflation fighters.  This could well be more than just a coincidence.  Both banks are in the midst of a major organisational transition, with Ben Bernanke having been appointed as the new Fed Chairman earlier this year and Otmar Issing about to retire as ECB Chief Economist at the end of this month.

On balance, we would expect the present inflation scare to blow over and consumer price inflation to ease back into the central banks’ comfort zone in the course of next year.  That said, as long as near-term cyclical inflation pressures are still on the rise — we don’t expect core inflation to ease any time soon — government bond yields may have to rise further. Only once signs of an economic slowdown in the second half of this year and into next year unmistakably manifest themselves and headline inflation starts to peak out should government bonds start to rally again, we think.

 

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Euroland
Too Much Communication?
May 22, 2006

Elga Bartsch (London)

Since the spring there seems to have been a subtle shift in the ECB’s communication policy, as the ECB has started to give more explicit guidance on interest rates.  Up to now, the guidance only referred to the very near term, i.e., the upcoming Council meeting.  But giving guidance on interest rates could potentially mark a more fundamental shift.  For the first eight years of its existence, marked by Professor Issing’s imminent retirement, the ECB has always tried to communicate its monetary policy decisions in the context of its two-pillar strategy.  The effort seems to have paid off.  Despite its short existence, the ECB’s interest rate decisions are already as predictable as the Fed’s (see The Predictability of the ECB’s Monetary Policy, ECB Monthly Bulletin, January 2006). 

I would argue that too much central bank communication on issue of the interest rates could in fact be counterproductive. There can be too much communication from a central bank such that a good thing could potentially become a bad thing.  This could be the case for central bank communications regarding future interest rates. Market participants will focus less on the reasoning behind a decision once they get guidance about future rate decisions.  Over time, the markets’ understanding of the central bank’s decision-making process could degenerate.  In addition, the central bank might also put itself into a tough spot because financial markets will typically read comments on future interest rates as an explicit pre-commitment.  If the underlying information changes significantly, the central bank might have to choose between what it should do and what it said it would do.

Central banks should therefore resist demands to give guidance on future interest rate decisions, in my view. Instead, they should use the interest their communication garners to educate market participants about their thought process. In my view, explicit guidance is not the best communication strategy for two reasons.  First, explicit guidance on future interest rates causes markets to disregard the discussion about the inflation outlook. They already know what they need to know. While explicit guidance on future interest rates isn’t desirable, in my view, more information on the ECB’s economic outlook would be very welcome.  Second, central banks can find themselves in a dilemma if the macro economic backdrop changes markedly. In this case, they can either be true to their mandate or true to their previous communication. Here the concepts of credibility and predictability need to be distinguished carefully.  In my mind, credibility is a long-term concept referring to whether or not a central bank delivers on its policy objective.  Predictability, by contrast, is a short-term concept referring to the ability to correctly anticipate specific interest rate decisions.  Both credibility and predictability are highly desirable.  A credible central bank will be able to firmly anchor inflation expectations. A predictable central bank reduces the near-term uncertainty about short rates. Together, they help to lower the risk premium in the bond market.  

At times, a trade-off between credibility and predictability might arise.  The May ECB Council Meeting might have been such a case. Unfortunately, the ECB seems to have chosen predictability over the credibility in this particular instance.  When confronted with a trade-off between credibility and predictability, a central bank should opt for credibility rather than predictability though (see also O. Issing, Communication, Transparency, Accountability —Monetary Policy in the Twenty-First Century, Federal Reserve Bank of St. Louis Review, 2005). Not having moved in May, the question now arises whether the ECB Council will make up for lost time by hiking 50bp in June.  At this stage, however, I would consider such a move an outside rather than a base case scenario.

It’s not just the central bank tying its hands by pre-committing to a certain course of action. Explicit guidance on interest rates will also affect the activities of central bank watchers.  It would change from a comprehensive economic analysis to a simplistic linguistic exercise. In my view, the ECB should attempt to give less guidance on interest rates, but it should provide more guidance on its economic outlook and, more importantly, the risks surrounding it.  The experience of the Federal Reserve shows that voicing diverging views on the economic outlook seems to enhance the market’s ability to predict interest rate decisions correctly. It’s the diverging comments on monetary policy that confuses it (see M. Ehrmann and M. Fratzscher, Communication and Decision Making by Central Bank Committees —Different Strategies, Same Effectiveness, 2005, ECB Working Paper No. 488).

Especially when central bank decisions are as data-dependent as they are at the current juncture, it is important not to create a false sense of security in financial markets about how much visibility the central bank has about the future path of interest rates.  As the recent experience of the Fed shows, it can be difficult weaning markets off being spoon-fed by policy makers.  Clearly, central banks should not add to uncertainty.  But they can also do little to reduce it below the level given by the uncertainty about the underlying economic situation and the inflation outlook.  In my view, this level is reached when the central bank’s policy approach is well understood and their policy actions are usually correctly anticipated by financial markets.  Trying to push beyond this point by providing direct guidance on future interest rate decisions is likely to be detrimental, in my view.  To quote Otmar Issing, “pretending that the world is simpler or more certain than it actually is, does not make a good recipe for monetary policy”.  I would even go one step further and maintain that too much communication on interest rates won’t likely be seen as a sign of strength — it’s more likely to be seen as a sign of weakness.

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Euroland
Could the Equity Sell-Off Choke the Recovery?
May 22, 2006

Eric Chaney (London)

The correction that shook equity markets last week is raising three questions.   What is causing the change in investors’ sentiment?  Are markets telling us something that we have overlooked?  Could the market turmoil choke the European recovery?  I will only touch on the first two questions and elaborate more in detail on the third one.

Will the chief anti-inflation cop will be tough enough?

As for the cause of the correction, the impression I get when talking to investors is first that markets are coming to grip with the idea that a long-lasting period of easy money is eventually coming to an end; and second that there are some concerns about the determination of the new Fed Chairman to anchor long-term inflation expectations in the “comfort zone” he had mentioned a couple of times.  Because of the leading role of US markets and of the Federal Reserve Board, this uncertainty is sending shockwaves around all equity markets.

Are we missing something big? 

Seen from a European angle, the answer is negative.  Although hard data are not as good as business surveys had suggested — for instance relatively disappointing French GDP, up only 2.2% SAAR in 1Q versus 2.4% expected by the markets — they are nevertheless confirming that the ongoing recovery is driven by domestic demand.  Take the French data for instance: consumer spending was up 3.7% SAAR and exports up 12.4%, a clear sign that demand is taking off in France’s main export market (Germany).  Hence, Europe, the second-largest importer in the world, is contributing, even if only modestly, to global growth.  From what we know, overseas exports are also quite robust, indicating that global trade, although not accelerating further, is growing at or above trend. 

The equity wealth effect, if any, is still largely positive

As of May 19, the broad Eurostoxx index was down 8% since its May 5 peak.  Could a further 10-20% correction have a significant negative impact on the real economy?  My short answer is negative.  Stock prices may influence the real economy through two main channels: a household wealth effect and the cost of capital.  Most academic studies have concluded that, in large continental economies, the equity-related wealth effect, also known as the ‘Pigou effect’, is unclear and probably very small.   In a note I wrote at the beginning of the stock market correction in January 2000, I estimated that a 10% drop in European equity prices might slice one-tenth from Euroland GDP, with a 2-3 year lag (A Positive Wealth Effect, Eric Chaney, January 7, 2000).  This was based on 1997 valuations, so that today’s multipliers are probably slightly larger.  Let’s assume that a 20% correction would cost 0.3% of GDP after 2-3 years.  However, one cannot abstract one’s self from past changes.  Using monthly averages, the euro area stock index is still up 33% from a year ago, suggesting that there is still a significant positive effect in the pipeline.  I would then argue that it would take at least another 25% correction to neutralise the positive Pigou effect resulting from past changes. 

A further 30% equity price correction would have a real effect

The second channel, the cost of capital, is even more difficult to quantify, since the average continental company is relying more on bank loans or debt to finance its projects.  Nevertheless, equity markets matter for large caps and, beyond this particular universe, equity prices are seen by corporate managers as indicators of liquidity conditions.  All in all, I consider that it would take at least a further 30% contraction in equity prices to have a significant negative impact on the real economy.  In addition, a large sell-off in equities would most likely initiate a re-allocation of funds into bonds and thus ease long-term interest rates, which would have a soothing influence by reducing borrowing costs.

At this stage, and assuming that the ECB’s anti-inflation credibility remains intact after the departure of Pr. Otmar Issing, the equity sell-off is more likely to trigger a portfolio re-allocation in favour of euro area government bonds than to harm the economy, in my view.  By contrast, oil prices, which have only slightly corrected, and the euro exchange rate, which has risen by 3.5% since the beginning of the year, are more serious threats to growth.  But that is another issue.

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Turkey
Broken Clocks
May 22, 2006

Serhan Cevik (London)

Like a broken clock, the catastrophist premise becomes a norm every once in a while. In the past two weeks, the global financial markets experienced increasing volatility and sharp corrections in all asset classes. The Morgan Stanley All Country World Index, for example, posted a 5.5% drop from the peak earlier this year. However, given the extent of speculative positions, commodity and emerging markets bore the brunt of the sell-off triggered by an inflation scare and the US Federal Reserve’s confusing communications. As the spread between nominal and inflation-indexed bonds in America widened from 234bp at the beginning of this year to 266bp last week, investors all around the world have become less complacent about underlying risks and started re-evaluating portfolio allocations. Unfortunately, coupled with apocalyptic arguments about recent domestic events, technical factors worsened the extent of the declines in Turkish financial markets. As the lira weakened to a two-year low and the benchmark interest rate increased from 13.6% to 15.4%, the catastrophists have started extrapolating tick data and declaring the end of the world. This is not the first time catastrophic predictions are in vogue in Turkey (see, for example, The Catastrophists, May 4, 2004). The country suffered similar bouts of volatility in 2003 with the war in Iraq, in 2004 when the Federal Reserve started raising interest rates, and even last year, to a lesser extent, because of the uncertainty surrounding the start of accession negotiations with the European Union.

Technical conditions in the Turkish banking sector intensified the global sell-off. Most of the Turkish investment community is trying to rationalise the sell-off with ‘bad news’ on the domestic front. Indeed, inflation was higher than expected last month, the central bank made a policy miscalculation and the president vetoed the pension reform bill. However, in our opinion, this is a global risk-reduction wave and the most important reason for the worse-than-all-other-markets reaction in Turkey is the banking sector’s short foreign currency position. Albeit within ‘prudential’ limits, Turkish banks increased their short foreign currency position from $3.1 billion in January to $9.3 billion at the beginning of May. And when foreign investors (holding 65% of the equity market and 13% of domestic government bonds) started reducing positions, Turkish banks made further losses on derivative products because stop-loss positions were triggered. As the short foreign currency position narrowed to $6.6 billion on May 12, the lira remained under pressure, and we believe that it is likely to experience a period of volatility until market participants readjust their currency and interest rate positions.

Turkey’s fundamental story is untouched, thanks to structural reforms and prudent policies. We warned in a series of articles that the disappointing process of appointing a new management to the Central Bank of Turkey could upset expectations, especially when global conditions are volatile and investors question even the credibility of the US Federal Reserve (see (Dis)appointment, March 31, 2006). Moreover, despite our optimism on the disinflation front, we also argued that cutting the policy rate before markets participants see the emergence of a downward trend in the year-on-year inflation rate is not a wise decision. Not surprisingly, last month’s reduction has become yet another excuse to scrutinise the central bank’s credibility and therefore to push real interest rates higher. Nevertheless, though significant, such mismanagement is not enough to justify fundamental alterations in Turkey’s story. With the heightened risk aversion, the lira may suffer distress, but the benefits of macroeconomic normalisation and globalisation will not disappear just because momentum investors got carried away. In our view, Turkey’s progress is a result of prudent policies and structural reforms, not just about a favourable liquidity cycle. Further, some volatility can indeed bring good by limiting speculative behaviour and purging economic excesses. This is why we still believe that as long as the government remains on a cautious path, the Turkish economy will weather the global storm.

Currency weakness likely to ‘correct’ the current account deficit on a sustainable basis. Purchasing power parity-implied fair value calculations show that the lira is indeed overvalued against the dollar as well as the euro. However, such measures do not incorporate structural changes that lead to an appreciation of the equilibrium value. Especially in Turkey’s case, rapid disinflation to the single-digit territory, fiscal consolidation that now makes the Treasury a net debt payer, and productivity-driven growth outperformance have justified a stronger exchange rate. That said, we were looking for a weakening in the lira, towards 1.42 against the dollar, because of the increasing burden of higher oil prices. That said, readings above 1.5 against the dollar are unjustifiable on macroeconomic fundamentals and also would not bring a ‘correction’ in the current account deficit. As argued in previous reports, Turkey’s current account deficit is a result of exogenous factors, such as higher oil prices and structural changes in the economy. With soaring prices in the global petroleum market, the cost of fossil-fuel imports increased to 6.2% of GDP and contributed to the widening in the current account deficit. However, the economy is already responding to price increases, as both the volume of energy imports and the current account deficit excluding energy imports keep declining on a sustained basis.

Strong growth and structural changes in the economy are behind the current account deficit. The Turkish economy grew at an annual rate of 7.4%, on average, in the past four years. Although pent-up demand and declining interest rates have fuelled the recovery in consumer spending, above-trend output growth and the corporate sector’s growing investment appetite are the real factors increasing the demand for imports of intermediate and capital goods, in our view. Since Turkey’s industrial complex has always been dependent on imported intermediate goods, the acceleration in structural adjustments away from labour-intensive to capital-intensive sectors has further increased the elasticity of import demand with respect to output and export growth. Some of these underlying changes reflect an encouraging process of creative destruction — moving from low value-added businesses to higher value-added industries — and the globalisation of supply chains. Moreover, the manufacturing sector, which accounts for a declining share of the economy, is still the leading engine of exports, creating a bottleneck in export growth and adding to external imbalances (see Post-Industrial Bottlenecks, January 11, 2006). However, we should not overlook the role of policy failures and institutional problems in changing production patterns in a way that increases import demand. For example, politically-motivated arbitrary wage adjustments have driven the marginal cost of labour higher relative to the cost of capital and thereby encouraged both imports of intermediate goods and capital-intensive production.

Turkey’s post-industrial economy is struggling with microeconomic bottlenecks. Although Turkey enjoyed a marked acceleration in labour and total factor productivity growth, industry-level data show sectoral divergences and increasing import dependency in certain industries. For example, productivity per hour worked in the clothing industry declined by 3.1% in the post-crisis period, whereas technology-intensive sectors like electronics and automotive enjoyed gains of 87.4% and 108.2%, respectively. As a result, real unit labour costs in the clothing sector increased by 15.6% against a 51.1% drop in the electronics industry. The key factor behind this divergence is technology –– only 21.9% of firms in the clothing sector introduced technological innovations against 80.6% in electronics (see Technological Sclerosis and Productivity Divergence, April 19, 2005). Therefore, it is technological backwardness –– not an ‘overvalued’ exchange rate –– that traps small, traditional firms in a vicious state of lower productivity and profitability and worsens Turkey’s external imbalances. This is why we believe that a weaker currency would bring no terms-of-trade improvement and cannot help addressing structural and institutional problems (see Of Lemons and Dinosaurs, March 1, 2006).

Despite microeconomic problems, the current account deficit reflects the economy’s strength. A current account deficit can either signal an unsustainable imbalance between national savings and investment or reflect the strength of a growing economy. Turkey’s gross savings rate increased from 17.5% in 2001 to 21.9% in 2004 and 23.0% last year — well above the long-term average, thanks to improvements in the public sector. The negative savings rate of the public sector declined from 9.1% of GDP in 2001 to 1.9% in 2004 and then moved into the positive territory (0.8 of GDP) last year. In other words, despite the significant correction in public savings, the drop in the private-sector savings rate lies behind the widening in the current account deficit. Within the private sector, the household savings rate declined from the crisis peak of 28.2% of GDP to 26.5% in the 2002-2004 period and then to 25.8% last year, while the corporate sector, responding to higher rate of return in the real economy, raised its investment spending, especially on machinery and equipment (see Big Picture, December 7, 2005). Though this marked increase in the capital stock has led to a widening in the current account deficit, it does not represent a risk and should actually improve Turkey’s international position in the future.

Fiscal discipline is the most important pillar of economic and financial stability. Turkey’s central government budget produced a primary surplus of 6.1% of GDP a year, on average, in the last six years, lowering the overall budget deficit from the peak of 16.5% of GDP in 2001 to 1.9% last year — well below the 3% threshold of the Maastricht criteria (see The End of Fiscal Dominance, November 8, 2005). Even though the growing pension shortfall is a major burden, the latest figures confirm the continuation of fiscal consolidation. In the first four months of this year, the budget deficit narrowed by 3.3% year on year to 28.8% of the year-end target, and will bring further reduction in the public-sector borrowing requirement (which already declined from 16.4% in 2001 to 0.8% last year). As a result, the public sector’s gross and net debt-to-GDP ratios improved from 107.5% and 90.5%, respectively, in 2001 to 69.8% and 56.5% last year. Further, there have been significant changes in the composition of public-sector debt that lessen the vulnerability of debt dynamics to currency and interest rate fluctuations. First, the average borrowing maturity in the domestic debt market increased from nine months in 2002 to 28 months last year. Second, the share of foreign exchange-denominated and linked instruments declined from 57.3% in 2001 to 38.9% last year. All in all, we believe that multi-year fiscal programming and structural reforms will continue anchoring inflation expectations and strengthening the Treasury’s future debt-service capacity.

The exchange rate ‘correction’ is likely to have a limited effect on domestic prices. The consumer price index posted a higher-than-expected increase in April, but the diffusion index declined to its lowest level, which means that the rise in inflation was due to specific items in the CPI basket, such as energy, gold and clothing prices. Of course, the lira’s sharp depreciation, if sustained, introduces new risks, especially given that new price indices are more sensitive to currency movements. Nevertheless, the exchange rate ‘correction’ is likely to have a limited effect on inflation. First, we are not convinced that the lira will remain as weak as it is now, because both macroeconomic fundamentals and the risk-reward profile remain supportive. For example, foreign direct investment, covering 42% of the current account deficit in 2005, is highly likely to exceed 60% of this year’s current account deficit. In the meantime, de-dollarisation of residents’ portfolio holdings will continue, though not as aggressively as in the past years, and support the lira’s valuation. Second, the exchange rate pass-through effect on inflation has weakened and its lag lengthened in the post-float period. Although this is an asymmetric link — that is, currency weakness matters more than currency strength — increasing competitive pressures and the slack in the economy should limit such adverse effects, provided that inflation expectations remain anchored to the central bank’s target.

There are far more powerful economic factors that drive inflation dynamics. Our inflation projections, already incorporating a weaker lira, are based on far more powerful exogenous and endogenous factors that determine the behaviour of inflation. First, the mix of monetary and fiscal policies remains restrictive, lowering the growth rate of disposable income from 6.4% in 2004 to 2.1% last year. Second, greater integration with the global economy creates competitive pressures, limiting the rate of price increases. Third, the continuing slack in the Turkish economy keeps domestic inflationary pressures under control. The unemployment rate increased to 11.8% in the first two months of the year, up from 11.5% a year earlier and the highest since 2002. In the meantime, the increase in real hourly wages amounted to 2.9% in the last four years, compared to a 32% rise output per hour worked, lowering unit labour costs at an unprecedented rate. Further, according to estimates, the unemployment rate consistent with price stability has declined in the post-crisis period, as a result of structural adjustments, and now dampens demand-driven inflationary pressures. On the production front, the outlook is even more encouraging. Thanks to the rationalisation of public finances, the increase in business investment spending has widened the margin of spare capacity. In other words, even after four years of above-trend growth, the Turkish economy is still operating with an output gap. This is why we have argued that the recent pick-up in inflation is a temporary phenomenon, reflecting higher energy prices and seasonal fluctuations.

In our view, there is no rational reason for calling early elections. The tension between the ruling government and the so-called political elite is nothing new. In every opportunity, the ‘establishment’ makes an effort to stimulate political fault lines, while the government brings up ‘sensitive’ issues to send messages to certain constituencies. Regrettably, these ‘noises’ provide the excellent background for developing conspiracy theories. The latest examples are next year’s presidential election and the attack on the Council-of-State judges. The media calls it the equivalent of 9/11 — ‘a violent attack on the secular and democratic foundations of the republic’ — and blames the government for inciting the assault, even though there is no direct or indirect link. Of course, these unfortunate developments hurt Turkey’s institutional credibility and threaten its economic stabilisation. After the establishment’s failure for decades to put the economy on a sustained growth path and to improve the country’s institutional credentials, political consolidation in the 2002 elections has allowed the coherent implementation of prudent policies and structural reforms, bringing a sustained economic improvement. Therefore, we believe that maintaining the sense of political stability is key to further progress on institutional areas and to deal with historical baggage.

Markets’ gloomy view on the economy creates a buying opportunity, in our view. Institutional development is never a linear process and always full of challenges. However, despite zigs and zags, Turkey will remain on the European convergence path, in our opinion, so long as the government keeps the reform momentum moving forward. But addressing macroeconomic issues is in fact the easiest phase of normalisation. This is why we have long argued that the authorities must focus on microeconomic and institutional shortcomings to ensure the sustainability of macroeconomic stabilisation as well as to keep the economy on a welfare-enhancing growth trajectory. Interestingly, such an approach would help the government, more than subsidies and other distortionary measures, to accelerate employment growth — scoring higher in next year’s election — and also allow the central bank to keep the easing bias — more scores to the government. All in all, judging from the latest price movements, we think that the market has become too gloomy on the economic outlook. With the lira’s valuation now in line with our forecast profile, especially the long end of the domestic yield curve looks fairly attractive. However, before giving the ‘buy’ order, one needs to become more comfortable with the Federal Reserve’s action plan.

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Israel
Hike Now, Pause Later
May 22, 2006

Serhan Cevik (London)

As the Israeli economy grows at an above-trend pace, inflation rises above the target range. The consumer price index increased by 0.9% month on month in April and 1.5%, on a cumulative basis in the first four months of the year. As a result, the twelve-month inflation rate surged from 2.4% at the end of 2005 to 3.8% last month, which is above the central bank’s target range of 1-3%. Further, the seasonally adjusted CPI posted an annualised increase of 4.0% over the last three months in April, up from an average 2.6% last year. In our view, the acceleration in inflation cannot be explained away by the rise in oil and other commodity prices or the lagged effect of the shekel’s weakness last year. Even though higher energy quotes and seasonal adjustments (in food and clothing prices) have certainly added to inflationary pressures, there are more fundamental changes in the behaviour of inflation. In the past, the shekel’s weakness was the principal factor driving inflation higher, but as the Israeli economy has kept growing at an above-trend pace, demand-side developments are now far more important for inflation dynamics.

Higher energy prices are a risk, but demand-side factors are the real threat, in our view. The shekel’s strength lessens inflationary pressures in exchange rate-linked sectors. However, that alone is not enough to alleviate upside risks stemming from energy-driven cost increases and, more importantly, from demand-side developments in the Israeli economy. As a matter of fact, if we exclude the housing category (which posted a monthly drop of 0.6%, thanks to the shekel’s recent appreciation against the dollar), the CPI actually increased by 1.2% last month. In our opinion, the broadening strength of economic expansion is now the most important determinant of the inflation outlook. Even with a gradual recovery in the labour market, the overall slack in the economy is diminishing fast and pointing to domestic costs pressures and greater pricing leverage. Globalisation may still help suppress inflationary pressures, but the pace — and changing composition — of output growth is no longer consistent with price stability in the long run.

Real GDP growth accelerated to an annualised rate of 6.6% in the first quarter. The Israeli economy continues to grow at an above-trend pace, even gaining further momentum, as the output recovery process turns into a proper expansion. According to preliminary figures, real GDP increased at an annualised rate of 6.6% in the first quarter of this year, up from 5.6% in the fourth quarter of 2005. Thanks to surging private consumption (10.3%) and fixed investment spending (16.3%), the annualised rate of increase in business-sector GDP reached 10.6%, whereas the public sector experienced a 0.6% drop. Even discounting one-off factors, the latest figures justify an upward revision in our real GDP forecast from 4.5% to 4.8% this year. This means that Israel’s business-sector GDP would be growing at a rate that is significantly above its potential growth rate for the third consecutive year. And, as a result of strong domestic demand and emerging supply constraints, the output gap will likely soon disappear altogether, in our view.

Monetary policy is still not restrictive in terms of nominal and real interest rates. The Bank of Israel already raised short-term interest rates by 175bp to 5.25%, which is, according to our estimates, the neutral rate of interest. This is not a very precise figure, but it still provides a reasonable point of reference for the monetary policy stance. In light of the latest macroeconomic figures and global developments, maintaining the current policy stance is not enough to keep inflation within the target range. This is why, with stronger-than-expected growth in the first quarter, we believe that the central bank should — and will — increase the policy rate by 25bp to 5.5% later this month and then to 5.75% at the end of August. Of course, our call depends partly on the shekel’s strength, which has recently functioned like monetary tightening. However, currency appreciation, albeit lowering the rate of price increases in exchange rate-linked categories of the CPI basket, cannot deal with broader inflationary pressures in the economy. As we argued in our previous reports, higher short-term interest rates reflect policy normalisation, not a threat to financial stability, and therefore are not an obstacle to a flatter yield curve.

 

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Japan
Rolling with the Punches (Part I)
May 22, 2006

Takehiro Sato (Tokyo) and Robert Feldman (Tokyo)

Modest downward revision of the economic outlook from the external environment and assumption changes

We slightly revise our 2006-07 outlook in light of Jan-Mar GDP. We lower our 2006 growth rate to +2.9%, but stick with our existing 2007 estimate of +2.3%. We raise the price outlook somewhat based on higher oil prices, but we still maintain our fundamentally bullish stance towards the economy and cautious stance towards prices. The economic outlook is more aggressive and the price outlook is more cautious than the consensus view.

Japan’s GDP growth rate slowed from +4.3% annualized in Oct-Dec 2005 to +1.9% in Jan-Mar 2006, mainly from a backlash rise in imports. Excluding this factor, the Japanese economy sustained a 2-3% growth rate over the two quarters with even stronger evidence of private-sector domestic demand momentum. There is not much chance of a significant near-term collapse of consumption activity, since nominal employee income has already expanded at a steady 1-2% YoY pace for four straight quarters and job confidence is strengthening. While inflation concerns have increased overseas, we expect rising productivity and fixed capital investments supporting these gains to drive sustained economic growth with stable prices in Japan. We remain optimistic on this point, in contrast to the consensus view, as explained later.

With regard to the prices, we have a cautious outlook for Japan’s core CPI at +0.4% in 2006 and +0.2% in 2007 as productivity advances from globalization and public and private-sector reform efforts in recent years curtail upward pressure on prices and the strong yen offsets some of the impact from high oil and primary products. This stance does not imply renewed deflation, as mentioned earlier. In fact, the combination of solid private-sector domestic demand and stable prices supports continued gains by asset markets.

The GDP deflator, meanwhile, is likely to continue encountering downward pressure from the high import deflator in Apr-Jun and beyond with expensive oil prices. We delay the anticipated timing of the return to a positive reading from Oct-Dec 2006 to Apr-Jun 2007 due to substantial changes in oil price and forex rate outlooks, especially for 2007, from our global economics team. Annual GDP deflator growth rates hence slip to -0.8% in 2006 and +0.3% in 2007. As a result, nominal GDP rates are +2.0% in 2006 and +2.7% in 2007, missing 3%.

However, the revisions reflect technical factors, such as the lower base effect due to revisions to the historical data, and the external environment, such as the higher oil prices. We have repeatedly emphasized the resilience of the Japanese economy to high oil prices with impressive energy efficiency and recycling of oil money, and recommend a focus on the domestic demand deflator or domestic final demand deflator, rather than the main GDP deflator value, which is strongly influenced by the import deflator. Therefore, bottoming out of the domestic demand deflator in Jan-Mar 2006 is good news in this sense, and we anticipate a steady improvement from this point. Readers should understand that changes to our main forecast values do not indicate a more bearish outlook. 

Productivity growth vital for sustained economic expansion

We do not make major revisions to private-sector domestic demand from our February outlook, in which we remain upbeat on consumption and capital investment. However, we notice a gap between our optimism and market caution toward productivity growth within recent gains in employee income. It is actually reasonable to anticipate slower productivity advances, with nominal employee income rising at a faster pace than nominal growth.

However, we see little chance of significant acceleration of wage growth, an important factor influencing productivity. Tight labor market conditions obviously place upward pressure on wages. However, companies are ensuring that total labour costs do not outpace profit growth even though this year’s spring wage negotiation (‘shunto’) resulted in the first base-pay increase in five years. Although wages rose more than labour market and production facility tightness in F2005, we expect no big wage momentum in F2006, relative to the tightness of production resources. Fears about wage inflation from a decline in experienced workers with a massive departure of older workers and mismatches in labour supply and demand are unlikely to materialize. The corporate sector is already promoting initiatives to maintain required skills at production sites while reducing labour costs, such as re-employment of experienced workers. Massive departures should also mainly occur in construction, utilities, agriculture and other industries with relatively low productivity and high average age levels. A lower ratio of workers in low-productivity industries should actually raise productivity for the overall economy.

At the same time, we are not unconditionally optimistic about productivity gains. Domestic capital investment must rise for a sustained recovery. We recognize some challenge to our bullish capital investment outlook from the first decline in core machinery orders in four quarters in Jan-Mar 2006 and the prospect of a further dip in Apr-Jun. Yet we also see positive trends, including automotive industry plans to maintain or exceed previous-year fixed capital investment in F2006 in the manufacturing sector and substantial facility upgrade demand in 1H F2006 from key non-manufacturing areas such as communications and electric power. Manufacturing capacity utilization is already near 77%, the peak from the second previous economic recovery phase. Real utilization is even higher than the nominal data since companies had been using older equipment (higher vintage ratio) due to restricting fixed capital investment in previous years, creating a stronger awareness of facility shortages than in 1997. We expect sustained productivity advances as rising fixed capital investment demand stimulates corporate production activity and creates a healthy shift from income to consumption.

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