ms 07092008

United States
The Perfect Storm Returns
July 08, 2008

By Richard Berner & David Greenlaw | New York

The US economy has thus far proved more resilient than we thought: We now estimate that first-half real growth ran at a 1¼% annual rate, while just a month ago we thought that the economy had been essentially flat in the first half of the year. That sizable difference owes importantly to tax rebates lifting consumer outlays sooner than we expected, plus the apparent resilience of business outlays for capital spending and the effect of strong growth abroad on US exports. In short, judging by recent data, the US economy appears to have skirted the recession we predicted back in December.



In This Issue

United States
The Perfect Storm Returns
China
China: Dissecting Policy Uncertainty
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The Global Economics Team


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


Read about other GEF team members



Forecast at a Glance

Year/year % change
2007E
2008E
2009E

Real GDP
2.2%
1.5%
0.7%

Inflation (CPI)
2.9
4.6
3.5

Unit Labor Costs
3.1
2.4
2.9

After-Tax “Economic” Profits
2.6
-5.0
-3.1

After-Tax “Book” Profits
4.3
-11.1
3.9


Source: Morgan Stanley Research E = Morgan Stanley Research Estimates



Nonetheless, we think that economic durability won’t last. In our view, the combination of tight financial conditions, higher energy quotes, higher global inflation and weaker global growth will soon promote a mild downturn. Specifically, we think that the economy will contract by a 1% average annual rate in the fourth quarter of 2008 and the first quarter of 2009, and that the economy will be flat over the four quarters ending in the second quarter of 2009. That weakness will pressure earnings and undermine risky assets for now, and will keep the Fed on hold at least into early next year. The combination of a steady Fed and rising inflation uncertainty means that the yield curve still seems likely to steepen bearishly. Here’s why.

Most important, we don’t think the fundamentals have changed much from a month ago. Home prices have continued to fall, stock market wealth has declined, energy prices continue to rise, earnings and hiring have been disappointing, and central banks abroad, including the ECB, have tightened. As we discussed last month, we think that four adverse feedback loops will undermine future growth: The housing-credit interplay is undermining consumer wealth and ability to borrow. The supply-induced surge in energy prices will probably depress US and global growth. A profit and lending squeeze will likely slow capital spending and hiring. Finally, rising inflation and inflation expectations have promoted tighter monetary policy in Europe and elsewhere (see “The Double-Dip Supply Shock,” Global Economic Forum, June 9, 2008).

Consumers Poised to Pull Back
However, American consumers have kept on spending despite a perfect storm of adverse forces – most evident in consumer sentiment falling to a 28-year low. Real outlays rose by a vigorous 3.1% annual rate in the three months ended in May. The most likely reason is that the impact of tax rebates on spending is occurring sooner — and the impact possibly will be bigger — than we anticipated. Earlier we judged that consumers might spend only 20% of their rebate checks, especially as rising food and energy quotes were a considerable offset. Now it appears that estimate was too low, perhaps by a factor of two. Moreover, it appears that consumers have drawn down existing home equity and other lines of credit to postpone the pullback — living on borrowed time. Courtesy of existing credit lines and widespread publicity about the rebates, consumers may even have spent some rebates in advance of receipt. Indeed, despite the declines in home prices, home equity loans at all commercial banks accelerated to 17.8% annualized in the thirteen weeks ended June 4.

That was then. The “borrowed time” is now running out, and we think a renewed slowdown is coming for the American consumer. Lending restraint, rising energy costs, slipping employment, falling home prices, and wobbly equity markets will all play a role. Anecdotal evidence suggests that lenders are cutting lines of credit and maintaining a cautious stance towards offering new ones, especially as home price declines become more widespread and credit quality deteriorates further. Indeed, home equity loans outstanding at commercial banks have stalled in the past month.

Meanwhile, discretionary income is under siege. The annualized rise in gasoline and other energy prices since the end of last year has already cost consumers $110 billion, wiping out the effects on discretionary income of the tax rebates over that timeframe. If crude oil quotes merely stabilize at current levels, gasoline prices likely will rise by another 25 cents or more, costing consumers another $33 billion annualized. Declines in nonfarm payrolls have averaged 73,000 in the past six months, cutting roughly $45 billion (0.6%) from annualized growth in wages and salaries. As we see it, therefore, the bigger the pop from rebates in the second quarter, the bigger will be the payback in the next few months after they are spent, unless energy prices tumble or consumers get addition lines of credit (see “The American Consumer: Stronger Now, Weaker Later,” Global Economic Forum, June 16, 2008).

Similarly, we think that business capital spending, which has been stronger than we expected, is likely to sag. There’s no mistaking recent strength: Based in incoming data on capital goods shipments and orders, industrial production in computers, and construction outlays, we estimate that real capex accelerated to a 5.7% annual rate in the second quarter vs. 0.6% in Q1. Some of the pickup may simply represent a temporary surge in project completions in hotels, offices and manufacturing facilities. The acceleration in equipment outlays may reflect a response to the investment tax incentives in the Economic Stimulus Act of 2008 (ESA). But fundamentals are deteriorating: Financing is more expensive and less available, cash flow growth is falling, operating rates are sliding, and the outlook has become less certain. In office and retail properties, vacancy rates are rising and rents are slipping, two time-honored catalysts for postponing expansion.

In addition, global growth looks set to slide. Among the culprits: Rising inflation, tighter monetary policies and the shock of higher energy prices, the latter magnified in several emerging market economies by reduced energy subsidies. Our European economics team believes that a manufacturing recession is already underway, and while the ECB welcomes slower growth to head off the potential for second-round effects to boost inflation further, the cost in terms of growth could be significant. While we don’t foresee recession in the emerging-market economies, risks are now pointed toward lower growth. Growth in Eastern Europe, in Asia and in Latin America still seems solid, but our teams think slowdowns have either begun or are coming in Turkey, India, Korea, Vietnam, Brazil, Columbia and Mexico. The 25% plunge in the Baltic Dry Freight Index over the past month hints that a more significant slowdown may now be underway.

This combination of domestic and incipient overseas weakness is a one-two punch for earnings. The earnings generated at home are suffering as operating leverage fades and companies can’t fully pass soaring costs through to customers. The ESA legislation has obviously made earnings (after tax) look better by providing a $38 billion corporate tax cut. But as with the rebates, this effect is temporary. What’s more, the same factors that are depressing earnings here are now hammering the one-third of earnings generated overseas. This shortfall recently has been the latest shock to equity investors who had hoped that decoupling would cushion Corporate America’s top and bottom lines. Finally, we think that the quality of earnings is suffering with rising inflation, as some of the reported gains are purely due to revaluation of inventories; those capital gains have little to do with operating results.

Despite the prospects for weaker growth, inflation risks are still tilted higher. For the first time in 35 years, we expect global forces will significantly push up US inflation, especially because there is a significant difference in the global inflation story this time from past inflation scares. Lax monetary policies abroad, especially in economies in which currencies have been pegged to the dollar or where officials maintained them at undervalued levels, has pushed up inflation in many regions. And being the product of past monetary policy laxity, it seems likely to be lasting rather than transitory. By our count some 50 economies around the world are now posting inflation above 10% (see “The Double-Digit Inflation Club,” The Global Monetary Analyst, June 25, 2008). Indeed, in many of those economies, we expect rising inflation and the policy response to it will be the source of weaker growth ahead.

This rise in global inflation, apart from any weakening in the dollar, threatens to raise further the prices of US imports and to push up US inflation expectations. One measure of longer-term inflation expectations – the University of Michigan’s 5-10 year surveyed median – has risen to a 13-year high of 3.4% in May and June, although a 1yr-7.5yr distant forward measure has been stable over the past 15 months. Increased energy, food, and import quotes threaten to spill over into domestic pricing. For example, import prices for nonauto consumer goods accelerated in May to 3.6%, a 16-year high, threatening to boost the prices of those and competing domestic goods at the retail level. And inflation uncertainty has also risen, likely contributing to the sense that a new inflation regime has arrived (see “Hedging Inflation Risks: Opportunities and Pitfalls in US Products,” Global Economic Forum, June 23, 2008).

Slack in product, housing and labor markets and hearty productivity gains will help blunt that threat, but measures of slack and their relationship with inflation are highly uncertain. Empirical studies suggest that this relationship has loosened over the past decade, implying a flatter Phillips curve. Now that inflation may be rising, the flatter Phillips curve means that the cost of bringing inflation down — the “sacrifice ratio,” or how much output or employment must be lost to reduce inflation by 1% — may have risen or that it will take longer than in the past. The implications: Investors and policymakers under current circumstances cannot count on a soft economy to keep inflation in check, and in any case, that’s probably a story for 2009, not now (see “Global Inflation, Economic Slack and Monetary Policy,” Global Economic Forum, June 30, 2008).

For their part, Fed officials still face the dilemma of rising inflation risks even as the odds for weaker growth are still elevated. Against that backdrop, the FOMC last week gave no hint that action was likely soon, and weaker growth through early 2009 means that the timing of the Fed’s first tightening move is less clear. Of course, if we are right that these global sources of US inflation are not transitory and the upside risks to inflation persist, talk alone will not suffice. Fed Chairman Bernanke will have an opportunity to clarify the nature of those risks at his semi-annual Congressional testimony in a couple of weeks. But if the economy starts to regain momentum in the spring and inflation is still running uncomfortably high, we have no doubt that officials will begin to take back their easing moves.

The combination of higher inflation and a flatter Phillips curve probably means that the process of bringing inflation back down will take longer than is currently in the price. While that process is underway, uncertainty about inflation, global growth and monetary policy will weigh on markets and investors — which is not a happy combination for risky assets. And rising inflation uncertainty means that the yield curve still seems likely to steepen bearishly.



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China
China: Dissecting Policy Uncertainty
July 08, 2008

By Qing Wang | Hong Kong


Policy Uncertainty Remains
We discussed policy uncertainties in late March (see China Economics: Dissect the Policy Uncertainties: A Revisit to Our Four-season Framework, March 26). Back then, our conclusion was that, despite record-high inflation in February, “We maintain our call for an ‘imported soft landing’ as the baseline scenario, with the potential policy mix featuring three ‘No’s’: no campaign-style administrative tightening, no large one-off revaluation of the renminbi exchange rate, and no aggressive interest rate hikes.” In particular, we reiterated our ‘no rate hikes throughout the year’ call.

Although the economic and policy developments have since been broadly in line with our expectations, the current policy uncertainties remain as large as three months ago. Specifically, we believe that the high-level policy meeting concluded on June 13 signaled a meaningful shift in the policy priority from “preventing overheating and broad-based inflation” towards “pro-growth and pro-stability” (see China Economics: Policy Priority Shifts Toward Pro-growth and Pro-stability, June 15). However, the PBoC governor’s recent remarks on taking a “stronger” anti-inflation policy stance have led to renewed speculation about an imminent interest rate hike, which has substantially weighed on market sentiment. How should these seemingly contradictory messages be interpreted?

Currency Appreciation versus Energy Price Normalization

In the policy debate regarding how to help China rebalance its economy, there have been two camps. One camp believes that the imbalances in the economy – including the large and persistent trade surpluses and stubbornly high investment growth – have reflected a fundamentally undervalued exchange rate, and therefore currency appreciation is the most important solution.

The other camp argues that the competitiveness of Chinese producers/exporters can largely be attributed to the artificially low prices of energy and other natural resources. To correct external imbalances, the policy priority should be given to deregulation and normalization of these prices to allow them to reflect the true opportunity costs. Exchange rate appreciation should only be a subsequent step. Without the price normalization, there is no way that the degree of renminbi undervaluation can possibly be determined with any accuracy.

In practice, the Chinese authorities took a balanced approach at the beginning by trying to make gradual progress on both fronts. However, as international oil prices kept rising rapidly and domestic inflation pressures intensified, the pace of energy price normalization slowed substantially. Authorities may have hoped that the rapid increase of international oil prices would be temporary and they could wait until prices declined or domestic inflationary pressures eased to resume price normalization. On the other hand, with widening trade surpluses, the case for currency appreciation has become increasingly easy to make. In addition, currency appreciation helps contain inflationary pressures. In this context, currency appreciation appears to have played a more prominent role since 2H07.

However, the surge in international oil prices since the beginning of this year and the attendant consequences (e.g., mounting financial losses of oil companies, the fiscal burden, and domestic shortages) have essentially muted this policy debate. Going forward, deregulation and normalization of domestic energy prices will likely be given priority over exchange rate appreciation, in our view. It seems to us that this is forced upon China by reality rather than a deliberate policy shift by choice. In this context, we expect energy price normalization to replace currency appreciation as the primary driver in China’s effort to rebalance the economy in the next 12 months.

Inflationary and Job-Protection Adjustments

Choosing energy price normalization over currency appreciation as the primary policy driver has two important implications:

First, it is a choice of inflationary over disinflationary adjustments. The direct impact of currency appreciation is disinflationary, as it helps to lower the domestic prices of imported goods. The direct impact of energy price normalization is inflationary, as energy price increases tend to lead to ‘cost-push’ inflation.

Second, it is also a choice of job protection over profit margins protection. Currency appreciation directly hits the export sector, especially inefficient, low value, and labor-intensive exporters, which will likely be forced out of the market as a result of appreciation, leading to job losses. Energy price normalization directly hits those inefficient and energy-intensive sectors, as higher costs of energy inputs squeeze profit margins.

Against the backdrop of moderating economic growth, between currency appreciation and energy price normalization, we view the latter as the lesser of two evils. Both currency appreciation and energy price normalization will eventually help to address the underlying imbalances in the economy. Ideally, reform measures should be pushed ahead on both fronts simultaneously. However, the best window of opportunity for undertaking these reforms appears to have been missed. Now that an export-led slowdown is well underway and international oil prices have risen to unprecedented high levels, normalization of domestic energy prices has become the feasible and preferable policy approach to achieve the objective of rebalancing the economy, in our view.

Challenge to Monetary Policy: Whither Rate Hikes?

If our assessment of the future policy course is correct, it will pose a considerable challenge to monetary policy. Deregulating energy prices – with domestic inflation still high – runs the risk of exacerbating inflation dynamics, as cost pressures increase. The currently high CPI inflation has been mainly attributable to very high food price inflation, and the recent decline of headline inflation has reflected a significant easing in food price inflation. Non-food price inflation – albeit still low at 2%Y – has been creeping up. The policy challenge is, as food price inflation softens and energy prices are deregulated, to prevent the headline CPI inflation from reaccelerating.

The key to preventing cost-push inflation from energy price deregulation is to ensure inflation expectations are well managed. An orthodox policy option is the central bank hiking interest rates. However, hiking interest rates in China is not as much of a ‘no-brainer’ policy option as it seems. Specifically, since the economy is cooling, a rate hike at the current juncture could exacerbate the downside risks to the growth outlook. We therefore do not believe that the authorities will take this risk, especially in view of the recent shift in policy priority from “preventing overheating and broad-based inflation” towards “pro-growth and pro-stability”.

Since both the base lending and deposit rates in China are still administratively set by the central bank, a case can be made for asymmetric rate hikes that result in higher deposit rates, which help to manage households’ inflation expectations, and unchanged (or smaller increases in) lending rates, minimizing the negative impact on the growth outlook by not adding to firms’ financing costs. However, we attach a low probability to this policy approach. Here’s why:

First, asymmetric rate hikes will squeeze banks’ net interest rate margins (NIMs). In view of rising uncertainty over the asset quality of banks amid an economic downturn, especially that related to the real estate market, we doubt that the authorities want to squeeze the banks further. While both the balance sheet and earnings of the banks are in good shape at the current juncture, their robustness has yet to be tested by the upcoming economic slowdown. Until then, the authorities will be very cautious in implementing policies that could potentially hurt the banks, in our opinion.

Second, with the upside of lending rates largely capped by concerns about the negative implications for the growth outlook, we see little room for deposit rate hikes that can effectively help manage inflation expectations without hurting the banks.

A Think-Out-of-the-Box Policy Option: The GID Scheme

The authorities are pursuing multiple objectives but under considerable policy constraints. For the reasons discussed above, while we cannot rule out the possibility of asymmetric rate hikes, we attach a low probability to such a policy option. Even assuming a rate hike, the magnitude would likely be small (e.g., less than 27bp), in our view.

We instead argue that if inflation were to stay persistently high in the coming months as a result of domestic energy price increases, a ‘Government-financed Inflation-proof Deposits’ (GID) scheme – the objective of which is to manage inflation expectations – is the policy option of least resistance and thus more likely to be adopted than rate hikes (including asymmetric rate hikes).

We made a case for GID in early April (see China Economics: A Policy Proposal: Government-Financed Inflation-Proof Deposits, April 6). A GID scheme should achieve the same effect as asymmetric rate hikes but without much negative impact on the banks’ NIMs, in our view. Under a GID, the government subsidizes households – out of its own budget – with the objective of ensuring non-negative real interest rates on certain types of their savings deposits at the banks.

Under a GID, the government promises households that the purchasing power of their long-term deposits will not be eroded by the high inflation. Households will therefore see no need to withdraw their bank deposits to buy real goods and services to hedge against inflation. Knowing their bank deposits – which are still the main form of Chinese households’ financial wealth – are inflation-proof, households’ inflation expectations will likely be stable and their spending behavior less likely to change much to exacerbate inflation. Moreover, the authorities’ anti-inflation credibility would be enhanced by the GID scheme, in our view, because the government penalizes itself for not being able to bring inflation down. In this sense, the government’s incentive in tackling inflation is aligned with that of the households, and their anti-inflation efforts therefore should carry more credibility.

We think that the GID scheme could become the policy of least resistance because it would have a relatively small immediate negative impact on the economy. Although the higher effective nominal interest rates on long-maturity deposits are the key for the GID scheme, we suggest that this policy be viewed as policy-makers’ effort to enhance their anti-inflation credibility instead of a conventional monetary tightening. Unlike the traditional monetary tightening, which tends to bring about ‘pain’ in terms of output loss before ‘gain’ in terms of low inflation, successful implementation of a GID scheme would be positive for the economy and market in both the short and longer run, in our view.

In essence, a GID scheme would use fiscal policy instead of monetary policy to help manage inflation expectations. We estimate that if the GID scheme only covers three-year or longer maturity deposits, the cost would be about 0.3% of GDP. It is possible that some deposits of shorter maturity may be converted into longer-maturity deposits, when deposits of longer maturity are made inflation-proof. We estimate that assuming all deposits of 1-to-3-year maturity are converted into deposits of over three years, the cost would likely increase to 0.7% of GDP, which is still quite manageable, in our view. We estimate that this cost could be more than offset by potential fiscal savings as a result of a reduction of oil-related explicit and implicit subsidies.

Policy Uncertainty to Persist Nonetheless

As we wrote in our previous note on policy uncertainties, “we see little risk of an economic hard landing. The biggest risk to our call is not the ultimate outcome (i.e., soft-landing versus hard landing) but rather the process of getting there. A lack of effective communication strategy on economic policy on the authorities’ part may constantly create confusion and exacerbate the uncertainties, resulting in unwarranted large volatilities in the market.” (see China Economics: Dissect the Policy Uncertainties: A Revisit to Our Four-Season Framework, March 26).

In the same vein, we are afraid that policy uncertainties will not diminish anytime soon. While we are trying to dissect policy uncertainty, we realize that we in fact present a rather complicated picture, which many investors – especially those who are not particularly familiar with China’s policy-making – may find a bit confusing and non-transparent. What we are doing here is a positive analysis – namely making a call about what the authorities will likely do given the circumstances and their objective function – instead of a normative analysis (namely what policy-makers should do according to the ‘best practice’ in a typical market economy setting).

We believe that such a policy environment will help deliver decent headline GDP growth and the attendant positive implications for employment, which are important to countries depending on the sustainability of China’s demand. However, it may not necessarily translate into strong domestic equity market performance, in our view. This is because policy uncertainty and lack of transparency at the macro level tend to lead to lower earnings visibility and higher market volatility at the micro level.

Our Policy Call and Implications: A Recap

The Chinese authorities are walking a fine line between avoiding significant economic slowdown and tackling inflation. While a synchronized global slowdown poses a threat to China’s growth outlook, the sharp increase in international oil prices is forcing China to raise domestic energy prices despite the persistence of food price-driven inflation. In this context, energy price normalization will likely replace currency appreciation as the primary driver in helping China’s growth rebalancing in the next 12 months, in our view.

Since, unlike renminbi appreciation that tends to be disinflationary, energy price normalization is inflationary, the policy challenge is to strike a delicate balance between supporting growth and preventing the second-round effects of cost-push inflation by successfully anchoring inflation expectations. While asymmetric rate hikes could serve this purpose, we have doubts about their feasibility, because doing so would squeeze banks’ NIMs when there is considerable uncertainty over their earnings outlook and asset quality.

If inflation were to stay persistently high in the coming months as a result of domestic energy price increases, we argue that a GID scheme – the objective of which is to manage inflation expectations – is the policy option of least resistance and thus more likely to be adopted than rate hikes. We therefore maintain our ‘no interest rate hike this year’ call. We also do not expect any meaningful shift in the exchange rate policy, and maintain our year-end target for USD/CNY rate at 6.60.

If, as we envisage, energy price deregulation plays a primary policy role going forward, China’s headline CPI inflation will be increasingly influenced by the timing and magnitude of energy price deregulation. We expect food price inflation to continue to ease and, in this context, one more 10-20% hike of refined product prices is likely in 4Q08. While energy price deregulation would generate cost pressures and squeeze corporate profit margins, the headline CPI inflation would unlikely reaccelerate to previous highs seen early this year, especially if the policy measures that we envisage were to be implemented.