The Double-Dip Supply Shock

The Double-Dip Supply Shock
June 10, 2008

By Richard Berner & David Greenlaw | New York

A double-dip recession is coming, courtesy of soaring energy prices and the ongoing restraint from the housing downturn, falling home prices and tighter financial conditions. Despite recent economic resilience, we’ve trimmed our growth prognosis by three quarters of a point over the four quarters ending in Q2 2009 to 0.5% from 1.3% last month, with modest declines now likely in both the spring and autumn quarters. Surging energy prices likely will boost headline inflation to 5-5½% over the next few months, and risks are rising that the consequent escalation in inflation expectations will spill over into a more lasting increase in inflation. Our year-over-year inflation forecasts (in terms of the CPI) for both 2008 and 2009 are now 70 bp higher in both years, at 4.6% and 3.5%, respectively. Although we think that the current episode is quite different from the miserable 1970s economy, the result − like that long feared by our colleague Joachim Fels − will feel like a prolonged whiff of stagflation. Indeed the risk is that the 1970s ‘misery index’ − the sum of the inflation and unemployment rates − will rise above 11% at some point in the next year. We have long agreed that investors should pay heed both to downside risks to growth and upside risks to inflation. Here’s why.



In This Issue

United States
The Double-Dip Supply Shock
United States
Review and Preview
Emerging Markets
Emerging Markets: The Abundance Upgrade
Brazil
Taylor-Made Monetary Policy
China
China: Will China Be the Next to Raise Retail Fuel Prices?
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The Global Economics Team


Qing Wang
Qing Wang is an Executive Director and Chief Economist for Greater China.


Ted Wieseman
Ted Wieseman is a Vice President and an economist focusing on US fixed income markets.


Gray Newman
Gray Newman is a Managing Director and senior Latin America Economist who is in charge of all Latin American macro-economic research.


Read about other GEF team members



Forecast at a Glance


2007E
2008E
2009E

Real GDP
2.2%
1.2%
0.9%

Inflation (CPI)
2.9
4.6
3.5

Unit Labor Costs
3.1
2.4
2.9

After-Tax “Economic” Profits
2.6
-6.2
0.9

After-Tax “Book” Profits
4.3
-12.0
-5.3


Source: Morgan Stanley Research E = Morgan Stanley Research Estimates





First-Half Resilience

This most recent downgrading of our growth prognosis may seem strange at first blush. Despite a prolonged housing downturn, the influence of a credit shock, and the early effects of the recent surge in energy quotes, there’s no mistaking the better-than-expected performance in recent and incoming data for the first half of 2008. First-quarter real growth was revised higher to 0.9%, and we expect a further upgrade to 1.1%. And we now expect a second-quarter decline of just 0.7%, compared with 2% last month. The reasons: Vigor in capital spending and the influence of strong global growth on net exports more than offset the headwinds buffeting housing and consumer outlays.

As evidence, a healthy 4% jump in April nondefense capital goods orders and increases in shipments point to smaller declines in business equipment spending than we thought last month. Strong April results and upward revisions to prior months’ data for nonresidential construction indicate a sizable increase in Q2 spending. And while exports tumbled in March, possibly reflecting the first signs of slower global growth, imports plunged by more, suggesting more support from net exports than anticipated. Finally, expected price hikes may be prompting some firms to buy goods in advance and hold them in inventory, limiting the slide in stockbuilding.

Indeed, there is a risk that the tax rebates for individuals and the business tax incentives in the Economic Recovery Act of 2008 will promote a stronger result than the 0.7% decline we estimate for Q2 real GDP. As of the end of May, consumers had received $50 billion in tax rebates. Although vehicle sales remained depressed last month, May’s better-than-expected retailing results at chain stores could reflect the first signs that consumers will spend a portion of the rebates sooner than we think. Likewise, the “use-it-or-lose-it” nature of the investment incentives may be triggering some capex gains, albeit at the expense of 2009.

Four ‘Adverse Feedback Loops’

Nonetheless, the analytics we see unfolding point to more economic weakness ahead. In particular, four ‘adverse feedback loops’ create downside risks to growth, especially to the consensus view that the economy has skirted recession and that a stronger second half is likely.

First, the interplay between the housing downturn, falling home prices, deteriorating credit quality, and lender caution is undermining consumer wealth and ability to borrow. With inventories of unsold new homes still at 10.6 months’ supply, and foreclosures contributing to resale availability, a further 30% decline in 1-family housing starts seems needed to bring supply into balance with demand. Although housing affordability has improved with falling home prices and interest rates, price declines are keeping would-be buyers and lenders cautious. The first-quarter rise in delinquencies on 1-4 family loans reported by the Mortgage Bankers’ Association and chargeoffs on residential mortgages reported by banks − to 6.4% and 0.8%, both new records − has doubtless reinforced that caution. Household net worth in relation to income has declined by 35 percentage points (to 533%) in the 15 months ended in March. Recent surveys from the University of Michigan suggest that cautious consumers “are more interested in reducing their debt and increasing their savings,” and 57% of respondents opined that banks were less willing to lend than before. So while our assumption that only 20% of the tax rebates will be spent may be too low, these factors suggest that their impact will nonetheless be limited.

The second adverse feedback loop stems from the supply-induced surge in energy prices that will undermine discretionary income in the US and abroad, probably depressing consumer spending and challenging the vigor of global growth. If gasoline prices nationwide peak at $4.25/gallon − hardly a bold forecast given the 20-cent surge in wholesale gasoline prices last week and the fact that prices averaged $4.03/gallon the week before − and if food prices rise at a 4.2% annual rate between May and September, the rise in food and energy quotes will have drained nearly $180 billion annualized from consumer budgets between December 2007 and September 2008. By comparison, the rebates will total $117 billion over all of 2008. Outside the US, countries such as India, Indonesia and Malaysia are reducing the subsidies that have long helped their consumers pay below-market prices for energy. The resulting price increases, combined with those in many other economies around the world, will erode spending power and thus global growth (see The Oil Shock Debate: Recession, Inflation or Both?, May 27, 2008).

A third feedback loop involves slipping profitability, tighter financial conditions and economic uncertainty that will likely slow capital spending and hiring. This feedback loop is especially important for lenders: Weaker economic growth will erode credit quality and make lenders more risk averse, tightening lending standards further. While capital spending seems to be holding up for now, hiring is clearly fading. Nonfarm payrolls have declined by an average 65,000 in each of the last five months, and for all the talk of how little payrolls have declined in this slowdown, the current pace is identical to the pace of decline seen in the first five months of 2001. Combined with sliding real wages, these job declines signal declines in real wage and salary income for the first time since 2001.

Finally, rising inflation and inflation expectations in Europe likely rule out monetary ease and could prompt the ECB to tighten (see ECB Watch: No Longer Ruling Out a Rate Hike, June 5, 2008). And in many emerging market economies − including China, where officials just announced a 100 bp hike in the ratio for required reserves, and Poland, Turkey, Israel, South Africa, Brazil, Peru and Columbia − officials likely will tighten monetary policy further to fight rising inflation. ECB officials and those elsewhere will welcome slower growth to bring down inflation pressures, and it seems likely they will eventually get their wish.

For the first time in 35 years, we expect global forces will significantly push up US inflation, and the Fed faces the most serious inflation threat in a decade or more. Surveyed inflation expectations are rising sharply, echoing rising energy, food, and import quotes, and those hikes now threaten to spill over into domestic pricing. Measured by the University of Michigan’s 5-10 year median, inflation expectations rose in May to 3.4%, a 13-year high. The doubling in energy quotes over the past year is affecting pricing in a broad array of industries, including transportation, agriculture, chemicals, construction and construction materials. Thus, core intermediate goods producer prices rose at a 9.4% annual rate in the six months ended in April, and more hikes are coming. Prices for imported consumer goods excluding motor vehicles rose by 2.8% in April, the fastest pace in 15 years.

These developments potentially could create a vicious inflation circle, because the rise in energy, food and import prices is affecting inflation expectations. And we’ve long argued that the dollar and oil prices might become locked in a vicious circle of their own, as oil producers seek to hedge their currency risks with higher prices. The good news is that these inflation pressures do not so far appear to have filtered into the wage setting process. Instead, they are squeezing margins in private industry and budgets for state and local governments. Over time, growing slack in product, housing and labor markets and hearty productivity gains will help mitigate the threat of a wage-price spiral. But that more benign picture is a story for 2009, when operating rates slide more significantly and the jobless rate rises to 6%, not now.

This setting clearly poses a dilemma for the Fed. As we see it, the resolution lies in leaving monetary policy on hold until spring 2009 − far longer than is currently priced in to financial markets. Indeed markets oddly are priced for a first rate hike as soon as the late-October FOMC meeting, just when the stimulus from tax rebates will be fading, and at least some “payback” in growth is highly likely. Despite the coming economic weakness, the rise in inflation and surveyed inflation expectations means that the Fed is unlikely to ease monetary policy again. Those inflation increases have reduced real rates, making policy effectively more stimulative. They also threaten to erode the Fed’s track record and credibility in keeping inflation in check. Chairman Bernanke’s warning that the dollar’s decline has boosted inflation is one aspect of the Fed’s concern. As a result, we think policymakers are on hold and will tolerate and even welcome economic weakness to cap inflation and eventually bring it back down.

For investors, that policy stance will continue to shape risks to the yield curve. With the Fed anchoring short-term rates, rising inflation risks will put a floor under long-term yields and could push them above 4% again. Rising oil prices and inflation uncertainty probably will promote a bearish steepening in the yield curve. Indeed, our colleague Manoj Pradhan provides tests suggesting that core CPI inflation volatility has been a structural driver of breakeven inflation, implying that investors should be compensated with a higher inflation risk premium and breakevens (see “Breakevens to Break Even Higher?”, The Global Monetary Analyst, June 4, 2008). Our rates strategy colleagues Jim Caron and George Goncalves are concerned that inflation risks might begin to shift the entire yield curve higher. But weakness in the economy likely will cap real yields and limit the sell-off for now, keeping 10-year yields roughly in a 3¾% to 4¼% range through year end.



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United States
Review and Preview
June 10, 2008

By Ted Wieseman | New York


A volatile week across almost all markets ultimately wound up with Treasuries posting strong front-end-led gains that largely reversed the prior week’s big sell-off but left the curve substantially steeper. The market rallied early in the week on renewed financial sector fears that had previously been steadily waning since the mid-March panic, as investors worried about upcoming earnings reports from several major companies with May quarter-ends, management changes at some big banks, reports about the possibility of substantial needs for more capital raising, and some reintensification of general systemic concerns (the reappearance of which was highlighted by Lehman Brothers’ seeing the need to issue a statement mid-week denying that it had used the Fed’s primary dealer credit facility). These concerns were then largely set aside from Wednesday afternoon through early Friday, with the market selling off as investors shifted their attention back to potentially more hawkish monetary policy and renewed inflation worries. These fears were first increased by Wednesday afternoon comments from Fed Chairman Bernanke that in comparing the current situation to the Great Inflation of the 1970s made clear that conditions now are far less dire, but did note that inflation is much higher than the Fed would like it to be and that some measures of inflation expectations have shown some concerning, though relatively modest, recent upside. ECB President Trichet followed this up by absolutely crushing the European front end Thursday morning when he unexpectedly warned of the possibility of a July rate hike. The US didn’t come close to matching the spike in European short-end yields, but was still dragged along to some extent by their huge losses. Trichet’s remarks also fully reversed what had been a nascent rebound in the dollar and associated pullback in commodity prices sparked by dollar-supportive comments by Chairman Bernanke Tuesday, and the renewed dollar weakness raised domestic inflation and monetary policy fears in light of Bernanke’s Tuesday comments. During the Wednesday and Thursday weakness, the market was also pounded each day by a wave of mortgage-related paying in swaps that was such a major problem for the market in the prior week’s sharp sell-off and that sent swap spreads much wider on the week, largely in two relatively compressed bursts Wednesday and Thursday afternoon.

Throughout these back and forth market moves, economic data – which to that point had been overall stronger than expected, with somewhat better-than-expected ISM surveys and chain store sales in May and upside in construction spending in April that pointed to a smaller drop in 2Q GDP than we previously expected, with the main offsetting negative being another month of abysmal auto sales – had been largely ignored. This changed Friday, however, when investors were shocked by one of the biggest one-month spikes in the unemployment rate ever. In retrospect, the more surprising pattern for the unemployment rate was not that it reached 5.5% in May, but that it was steady at 5.0% from December to April despite steady payroll job losses. Still, the sudden catch-up was a stunning enough development to drive the market rallying sharply again to end the week. The Friday surge appeared to be more flight to quality than anything, though, as stocks, credit and the dollar tanked and commodity prices surged, since there was little corresponding change in Fed pricing and swap spreads blew out further, but this time not as a result of mortgage-related paying but of Treasury strength.

On the week, benchmark yields fell 6-26bp and the curve steepened in a major way, with 2s-10s up 14bp to 155bp and 2s-30s up 19bp to 226.5bp, highs in a month. The 2-year yield plunged 26bp to 2.385%, the 5-year 21bp to 3.195%, the 10-year 11bp to 3.94%, and the 30-year 6bp to 4.65%. Fed Chairman Bernanke’s attempt to talk up the dollar along with Treasury Secretary Paulson briefly had a fair amount of success that was accompanied by a significant pullback in commodity prices. Bernanke’s efforts were quickly undone by ECB President Trichet’s hawkish comments (faint echoes of 1987?), however, with the dollar ending more than US$0.02 worse for the week against the euro at US$1.578 and commodity prices going completely ballistic. After an amazing surge on Friday, July oil ended the week more than US$11 a barrel higher at a record US$138.79. July gasoline spiked US$0.20 a gallon US$3.55 – which would amount to about a further US$25 billion hit to consumers’ spending power if sustained. Agricultural commodity prices also saw major upside on the week, so food price inflation is likely to remain a major issue as well. TIPS had a mixed reaction to this. The very short end naturally outperformed significantly, but the outperformance faded moving into the intermediate part of the curve and then turned into significant underperformance at the long end. The 5-year yield fell 25bp to 0.73% and the 10-year 10bp to 1.43%, but the 20-year yield actually rose 2bp to 2.14%. When the market sold off Wednesday and Thursday, mortgage-related paying in swaps was a big reason why. Big moves higher in spreads on these days were added to by a further flight to quality-driven increase Friday. For the week, the benchmark 10-year spread jumped 10.5bp to 75bp and the 5-year 13.75bp to 94.75bp, the former the high since early March and the latter since mid-April.

Risk markets were volatile through the week (stocks more so than credit), but ultimately ended down significantly, with a particular poor day Friday greatly aiding the big Treasury rally. The S&P 500 lost 2.8%, and closed Friday at its lowest level since April 15. The investment grade CDX index was 14bp wider on the week at 116bp late Friday, which would also be its worst close since April 15. Through Thursday, the high yield index was only 10bp wider on the week at 581bp and even after falling about another three-quarters of a point Friday was still on pace to perform relatively well compared to investment grade. The leveraged loan LCDX index also performed relatively very well, moving only 2bp wider on the week to 354bp as of midday Friday. The commercial mortgage CMBX market showed modest downside on the week, with the AAA index widening 7bp to 113bp and the AJ (junior AAA) 11bp to 351bp, both still a good bit better than recent worst closes of 128bp and 411bp hit May 9. The subprime ABX market mostly continued sinking (the A index showed slight upside, but all the others dropped), with the AAA index dropping almost a point-and-a-half to 52.29, its worst close since April 1 after a six-point decline in the past three weeks.

There was little change in near-term Fed pricing in the futures market, with the timing of the first Fed rate hike still considered a close call between the October and December FOMC meetings, but a somewhat more dovish view for the end of this year and into next. The November fed funds contract gained 1.5bp to 2.125%, January 8bp to 2.255%, February 13.5bp to 2.395% and March 17.5bp to 2.465%. A 28.5bp gain by the Jun 08 eurodollar contract to 3.29% and 26.5bp rally by Sep 08 to 3.535% led gains in that market. 3-month LIBOR rose about 1.5bp on the week to 2.70%, which caused the spot 3-month LIBOR/OIS spread to rise marginally to 68bp. Eurodollar and fed funds futures prices are roughly consistent with this spread, rising towards 75bp by the middle of the month and holding there through mid-December.

The key round of early data for May was mixed. Most details of the employment report were in line with expectations, as the pace of job loss picked up again after moderating in April. The big shock in the employment news was one of the biggest monthly rises in the unemployment rate ever, though in retrospect the more surprising aspect was that the rate held steady for the four previous months as payroll employment declined. The May spike appeared to be a correction and catch-up of this prior apparent understatement. Meanwhile, the two ISM surveys were better than expected in May. The manufacturing index rose modestly, but was still just below the 50 boom/bust line, largely it seemed as a result of continuing strength in exports, while the non-manufacturing index dipped only slightly and held modestly above 50. Early indications for May consumer spending were somewhat mixed. Motor vehicle sales were awful again, further deteriorating after having plummeted in April. Chain store sales, on the other hand, were fairly sluggish, but somewhat better than expected.

Non-farm payrolls fell 49,000 in May, a fifth straight drop in overall employment and sixth straight for private sector jobs. Manufacturing (-34,000), construction (-26,000) and retail (-27,000) continued to post steep declines, while business services (-39,000) turned down again after a gain in April moderated the loss in overall jobs. The main offsetting positive continued to be strong growth in healthcare jobs (+42,000). Finance employment (-1,000) also continued to hold up much better than expected recently, given the turmoil in the sector and reports of heavy job cuts at banks and brokerages. The big shock in the employment report was a spike in the unemployment rate to 5.5% from 5.0%, one of the biggest monthly rises on record. This appeared to reflect a catch-up to past job weakness, as the rate had held steady from December to April despite a string of payroll job losses. The average workweek was steady at a near-record-low 33.7 hours, while average hourly earnings picked up to +0.3%. With aggregate hours worked down 0.1%, aggregate weekly payrolls, a proxy for total wage and salary income, posted a modest 0.2% rise, though this will likely be negative in real terms once the inflation figures are reported, given the recent spike in energy prices.

The manufacturing ISM composite index rose a point to 49.6 in May, holding just below the 50-breakeven level. The upside was accounted for by a good rise in orders (49.7 versus 46.5), though to a level still barely in contractionary territory. Strength in exports continues to provide significant support, with the export orders index at an elevated 59.5. Meanwhile, production (51.2 versus 49.1) moved modestly higher into growth territory, while employment (45.5 versus 45.4) was little changed at a weak level. The industry breakdown remained soft, with only 7 of 18 sectors reporting growth. The prices paid index climbed another 2.5 points to 87.0, the third-highest reading since 1979. A number of energy, metals, chemicals, paper and farm products were reported up in price. Meanwhile, the non-manufacturing ISM composite index dipped to 51.7 in May from 52.0 in April. Underlying details were more positive, as a sharp drop in the supplier deliveries index (51.0 versus 56.0) after a big rise the prior month was the biggest reason for the weakness. The employment gauge (48.7 versus 50.8) also fell a couple points into negative territory, but orders (53.6 versus 50.1) and business activity (53.6 versus 50.9) both rose a few points further above the 50 breakeven level. 13 of 18 industry groups reported growth in May, up from 12 in April, led by entertainment and, surprisingly, real estate and construction. The prices paid index rose 5 points to 77.0, the second-highest reading in the 11-year history of the data. A lengthy and varied list of items was reported up in price.

After plunging to their slowest pace since the 1998 GM strike in April, motor vehicle sales fell a bit further in May to a dismal 14.3 million unit annual rate from 14.4 million. And the mix was much worse than the dip in overall sales, as sales of cheaper cars jumped to 8.0 million from 7.5 million, while trucks plunged to 6.2 million from 6.9 million. This was the weakest month for truck sales since 1995 even as sales of imported cars jumped to a nearly 20-year high. Spiking gasoline prices are clearly having a major impact on consumers’ motor vehicle buying patterns. Meanwhile, chain store sales overall were relatively sluggish but somewhat better than expected. Sales at clothing and department stores were very weak, but discounted posted modest upside and clubs were strong. A large part of the upside in club sales, however, reflected surging gasoline prices. We look for retail sales to rise 0.7% in May both overall and excluding autos, though the bulk of this upside is expected to come from a price-related surge at gas stations (plus a boost to general merchandise from the upside gas prices provided to club store sales). Incorporating this estimate and the weak auto sales numbers, we trimmed our 2Q consumption forecast to 0.3% from +0.5%. Other data bearing on 2Q growth, however, predominantly a better-than-expected construction spending report for April that pointed to a surprisingly solid trajectory for business investment in structures, more than offset this weaker estimate for consumption and we boosted our 2Q GDP forecast to -0.7% from -1.0%. We also see 1Q GDP being revised up a bit further to +1.1% from +0.9%.

Retail sales on Thursday and CPI on Friday highlight a moderately busy economic calendar in the upcoming week. The Fed will release the Beige Book prepared for the June 24-25 FOMC meeting on Wednesday, and a number of Fed speakers are scheduled. Both Chairman Bernanke and Vice Chairman Kohn will be participating in a Boston Fed Conference on Understanding Inflation and the Implications for Monetary Policy: A Phillips Curve Retrospective, though Bernanke’s speech Monday night on Outstanding Issues in Inflation Analysis sounds likely to be more technical and academic in nature than market moving. There will also be supply to deal with, with the Treasury announcing the terms of the 10-year reopening Monday to be auctioned Thursday. The size will likely be held steady at US$10 billion after being boosted US$2 billion to that level at the March reopening in anticipation of a US$2 billion increase in the new issue size at the May refunding. Other data releases due out include the trade balance Tuesday, Treasury budget Wednesday and business inventories Thursday:

* We expect the trade gap to widen to US$61.2 billion in April, reversing most of last month’s big narrowing, with exports up 1.4% and imports rising 2.5%. Almost all of the import gain is expected to come from a price-related surge in petroleum products. Indeed, the American Axle strike likely kept auto imports depressed after the sharp fall seen in March, and port data continue to point to sluggish incoming shipments of other goods. On the export side, industry data and factory shipments figures point to a good gain in capital goods, led by aircraft. Meanwhile, a moderation in food prices following on the heels of the prior surge should lead to some flattening out in that category, but exports of industrial materials should show some further price-led upside.

* We expect the federal government to report a US$160 billion budget deficit in May, much larger than the US$68 billion recorded a year ago, largely as a result of nearly US$50 billion in tax rebate checks that were distributed in May. A calendar shift that resulted in almost all of the April 15 payments being processed in April this year instead of partly spilling over to May should also lead to a sharp fall in non-withheld taxes, and withheld income and payroll taxes appear to have been little changed from a year ago. Meanwhile, because June 1 was a Sunday, a big chunk of early June outlays were shifted into May this year.

* We forecast a 0.7% rise in May retail sales, overall and ex-autos. A price-related spike in sales of gasoline is expected to help drive retail sales higher in May. Indeed, excluding the gas station category, we look for non-auto sales to be up only 0.2%. And the motor vehicle sales reports appeared to translate into only a slight uptick in the auto dealer category following some significant softness in prior months. Meanwhile, the chain store reports showed somewhat better-than-anticipated results for general merchandise offset by softness at the apparel outlets. Finally, the tax rebate checks that were distributed starting in late April appear to have had only a minimal impact on May sales but will likely have a more noticeable effect in coming months.

* We look for a 0.4% rise in April business inventories. The surge in wholesale inventories should be partly offset by the flat reading for manufacturing and likely little change at the retail level as auto inventories continued to decline, leading to modest rise in overall stockpiles. The I/S ratio is likely to dip a tenth to 1.25.

* We forecast a 0.6% surge in the consumer price index in May and a 0.2% rise excluding food and energy. The seasonal adjustment factor for gasoline offsets some of the run-up in pump prices that occurred during May, but not nearly as much as in last month’s report. With food prices continuing to climb, we should see a sharp jump in the headline CPI. Meanwhile, the core is expected to be very close to +0.25% in May, implying that we see upside risk to our rounded estimate of +0.2%. One of the key factors again this month is expected to be hotel rates. Survey data point to some recent modest softening of room rates on an underlying basis, but the sharp fall-off seen in the April CPI report seemed overstated. So, we look for a partial rebound in May. Also, we expect to see some upside in the medical care component, which has been unusually soft over the past few months. Finally, on a year-on-year basis, we estimate that the core will just barely round down to +2.3%, which is where it stood in April.