MS June 16, 2008

Business Conditions: Sustainable Improvement or False Dawn?
June 16, 2008

By Richard Berner & David Cho | New York

Building on May’s increase, business conditions improved further in early June, with the Morgan Stanley Business Conditions Index rising seven points to 43%. While the index remained below the 50% threshold separating growth from contraction, this month is the second straight rise, netting to a 15-point gain from April’s low. What’s more, the June reading is the highest since October 2007, and even a 3-month moving average of this volatile indicator rose to a 2008 high. This good news seems to confirm better-than-expected recent data on retail sales, capital goods orders, exports, and nonresidential construction.



In This Issue

United States
Business Conditions: Sustainable Improvement or False Dawn?
Currencies
A Monumental Petro-Wealth Transfer
Emerging Markets
Central Europe: FX Loans Give Central Banks Plenty to Worry About
Baltics
The Euro at the End of the Tunnel
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The Global Economics Team


Stephen Jen
Stephen Jen is a Managing Director and Chief Currency Economist.


Oliver Weeks
Oliver Weeks is a Vice President who covers the EU accession countries.


Read about other GEF team members



Does this bullish combination suggest that the US economy is finally and sustainably on the mend? We strongly doubt it. Although there’s no mistaking the strength of recent data, all our analytics point to further weakness and suggest that this two-month improvement is just another false dawn. Here’s why.

The Case for Improvement

The macro case for improvement certainly has merit; after all, significant monetary and fiscal stimulus is in place, and they may now be overwhelming the headwinds facing the economy. And the vitality of global growth, which has long fueled an improvement in US export performance, seems so far intact. Bulls examining details of the June MSBCI canvass could cite several corroborative details. Echoing the narrowing in corporate credit spreads, our credit conditions index jumped 12 points to 45%, or the highest reading since the credit crisis began last summer. Our expectations index − a gauge of analysts’ sentiment − jumped 7 points to a 2008 high.

There’s more: Hiring plans doubled in June to include more than one-third of respondents, while capex plans increased to 50% − the highest level since January. Likewise, advance bookings held steady in June over 50%, and analysts have turned more positive on margins and earnings. Whereas in May, 46% of analysts expected margins to shrink at companies they cover, in June that share shrank to 30%. And while in May analysts expecting downside risks to earnings outnumbered those anticipating upside by nearly three to one (73% versus 27%), in June that proportion was almost evenly split (44% now look for upside risks versus 56% who see downside).

Energy and Materials Mask Weakness Elsewhere

Nonetheless, we think the case for renewed weakness is stronger. Among the headwinds: higher energy prices, an ongoing housing downturn, falling home prices and tighter financial conditions (see “The Double-Dip Supply Shock,” Investment Perspectives, June 12, 2008). The housing downturn is well advanced, but some of those forces − such as the most recent escalation of energy quotes − have yet to hit consumers, let alone business conditions. Indeed, consumers seem now to be defending their life styles with a combination of tax rebates and previously-arranged home equity and other lines of credit. None of these sources of wherewithal is sustainable. By design, the rebates are one-time boosts to income. And lenders are growing increasingly reluctant to extend new credit.

Moreover, there’s less to the breadth of the upswing in the aggregate MSBCI than meets the eye. Energy and materials producers are on a tear, not surprisingly, as conditions improved dramatically in those groupings. But except for IT, their strength comes at the expense of many other industry groupings that are energy and materials consumers. Conditions worsened significantly in consumer discretionary, financials, industrials, healthcare, and utilities. Expectations deteriorated in those industries as well as in telecommunications services and utilities.

That dichotomy widened the gap between our two major industry subindexes. All the June improvement came in the manufacturing subindex, which jumped 14 points to 61% (not seasonally adjusted), while the services subindex slipped two points to 29%. Likewise, bookings improved in materials, energy and IT, but deteriorated elsewhere. Hiring improved in energy and showed steady growth in healthcare, IT and materials, but worsened elsewhere. Hiring plans improved in energy, healthcare, IT and materials, but deteriorated modestly in others. Capex plans improved in those same industries, as well as utilities and consumer staples, while they deteriorated sharply in most others.

The pricing conditions index rose to a record high 75% in June, reflecting rising energy, commodity and import prices. A record two-thirds of respondents said that companies under their coverage raised prices, and 46% said they raised them by 3% or more. Sellers in energy, materials, consumer discretionary and healthcare all raised prices significantly. Prices declined in IT and telecommunication services.

Earnings Expectations versus Reality

Earnings optimism is broader based: Analysts expect margins to expand in energy, materials, utilities, healthcare and IT. Some of that likely stems from current pricing power: 53% of analysts reported in June that companies under their coverage raised prices as fast as or faster than their costs. In our experience, such analyst optimism typically outpaces reality, although a sluggish economy has narrowed the gap. More importantly, with the economy turning sluggish and operating rates slipping, such pricing power seems unlikely to last. That will put pressure on margins. Indeed, the quality of those earnings is becoming more dispersed, with sharp increases in the number of analysts reporting better or worse quality, and far fewer reporting no change.

For their part, market participants should heed the Hobson’s choice in this report, given today’s rising inflation concerns. If the improvement in business conditions is sustainable, earnings expectations might be realized, but concerns about inflation would likely escalate, in turn fueling expectations of Fed tightening and pushing up bond yields still further. Conversely, if the improvement fizzles, as we expect, there’s much more downside to earnings compared with today’s elevated expectations. Either way, risky assets may suffer.



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Currencies
A Monumental Petro-Wealth Transfer
June 16, 2008

By Stephen Jen | London


Summary and Conclusions

We are witnessing a monumental transfer of wealth to oil exporters, which may last beyond our generation. There will be important geopolitical and security implications. In this note, we highlight some of the economic and financial implications of this wealth transfer.

The Size of the Wealth Transfer

High and rising oil prices are the crux of many macro issues that are important to investors today. The outlook of the global economy, inflation and monetary reactions are all predicated on the trajectory of oil prices; none of these issues is close to being resolved, because the outlook for oil prices is so uncertain. High oil prices also lead to large wealth transfers from the world to the oil exporters. While this notion is well recognised, we provide some broad figures for your consideration.

Saudi Arabia, at today’s oil prices, is enjoying oil export receipts of some US$1 billion a day. Total daily oil export receipts are roughly US$2.0-2.5 billion for the GCC, non-GCC OPEC and non-OPEC exporters.

If oil prices don’t retreat back to the low double-digit levels, oil exporters will enjoy a massive wealth transfer from the rest of the world. As a rough calculation of the size of this transfer, we compute the market value of the proven oil reserves in the various groups of oil exporters.

At US$120 a barrel, the six GCC countries have US$58 trillion worth of proven oil reserves. If oil prices continue to rise, obviously the proven reserve valuations increase commensurately. At today’s oil price of US$135 a barrel, the stock of the GCC’s oil wealth is around US$65 trillion. (This averages out to roughly US$4 million per citizen, or US$20 million for a family of four, though in practice the oil wealth will not likely be distributed in this way.) As a reference for comparison, the world’s total public equity market capitalisation is around US$50 trillion.

Economic and Financial Implications

There are several important economic and financial implications from such a wealth transfer:

• Implication 1. High growth and high inflation. Large balance of payments (BoP) and fiscal surpluses have led to high growth in domestic demand in the GCC. The rapid build-up of aggregate supply, however, has been compromised by infrastructural constraints – mainly housing, as inward migration of foreign workers has been large. Inflation, therefore, has roots in demand as well as supply. As a result, inflation should not be dealt with via interest rates alone. In most of the six GCC countries, CPI inflation is now double-digits: 14.8% in Qatar, 11.6% in the UAE, 11.5% in Oman, 10.4% in Saudi Arabia, 10.1% in Kuwait and 2.7% in Bahrain. Policymakers have been trying to develop ‘downstream’ sectors related to oil and gas, so as to ‘broaden’ the hydrocarbon industry. (This has been a policy objection throughout the GCC, but in Saudi Arabia, six cities will be created to centre on various ‘downstream’ industries related to oil.) At the same time, policies are being put in place to encourage the development of private companies in the non-oil sectors to add to the family companies that have already thrived in these economies.

• Implication 2. Pressure on the currency pegs. As we have written in the past (see Delay in GCC’s Monetary Union Raises Reval Risk, February 7, 2008, and A Managed Float Is the Ultimate Goal for the GCC, November 21, 2007), we believe China’s move from a pegged regime to one that permits greater monetary independence might serve as a blueprint for the GCC. Caught in the policy ‘trilemma’, the GCC will be unable to tame demand-oriented inflation unless interest rates can be raised to positive levels. The sustainability of the current pegged regime is a function of social and political tolerance for the divergence between the ‘haves’ and the ‘have-nots’. Negative real interest rates fuel asset price inflation as well as goods price inflation – the former helps the ‘haves’ while the latter hurts the ‘have-nots’. So far, GCC governments have tried to offset the impact of goods price inflation through transfers and subsidies on various products. Public sector salaries have been raised significantly to compensate for high and rising inflationary pressures. They have also tried to ease inflationary pressures through postponement of public projects, allowing more building materials to be channeled to the private residential sector.

• Implication 3. SWFs as the primary vehicle for capital expatriation. OPEC’s C/A surplus is likely to exceed US$500 billion this year. Much of this savings surplus, as well as capital inflows, will be expatriated through SWFs. Our calculations show that oil-exporting SWFs now have about US$2.3 trillion in assets under management, and that this figure could exceed US$3.3 trillion by 2010. In contrast to two or three years ago, when the world’s savings deficit was concentrated in the US and the US C/A deficit absorbed some 80% of the world’s C/A surpluses, right now the world’s C/A surpluses are much more concentrated, with the oil exporters and China being the main surplus countries. The oil exporters are already highly reliant on SWFs as the main channel through which capital can be sent back out to the foreign financial markets.

• Implication 4. Depressing global real interest rates. The world still suffers from a problem of excess savings, in our opinion. As the US C/A deficit shrank (now below 5% of GDP, and expected to reach only 4.5% of GDP by year-end), the trajectories of the C/A surpluses of oil-exporting countries and China are fairly robust. This combination of a sharp decline in the US savings deficit and large savings surpluses in several parts of the world, including oil exporters, suggest that the world’s real interest rates should fall to equilibrate the world’s savings and investment. The G10 10Y real interest rate has just set a generational low of 1.35% – roughly half as high as the potential growth rate of the G10 economies. Another way to understand the low real yield is that the marginal propensity to consume is lower for the oil exporters than it is for the oil importers, despite the large spending on infrastructure by the former. As wealth is transferred from the latter to the former, the world’s interest rate should fall. Yet, another way of thinking about the low yields in the world is that SWFs could have invested their new proceeds in relatively safe sovereign bonds, waiting to deploy the capital into risky space when the global economic conditions improve.

Thoughts on the GCC Currency Pegs

We believe that most GCC governments are still committed to the USD pegs for the time being, and the reiteration of this commitment by Saudi Arabia, the UAE and Qatar last week during Secretary Paulson’s tour of these countries is credible. Most of the GCC countries emphasise ‘supply-driven’ inflation, and have the view that as long as growth holds up, a bit of inflation would be tolerable for now. However, over the medium term, the GCC’s dollar pegs will almost certainly be replaced by more flexible regimes, with or without a monetary union. We believe that there is meaningful risk of one or more GCC countries adjusting their pegs beyond 2008.

Bottom Line

We are witnessing the beginning of a monumental transfer of wealth to oil-exporting countries that may last beyond our generation. Saudi Arabia is earning more than US$1 billion a day from its oil exports, and the GCC hold some US$65 trillion worth of oil reserves, most of which will one day be consumed and the GCC will have converted oil into paper assets of this amount. There are geopolitical, economic and financial consequences from this wealth transfer.