Pushback
May 20, 2008
By Richard Berner | New York
Investors and issuers alike are pushing back on our bearish calls for economies and markets. Small wonder: They are relieved that the economic slowdown has so far been mild both here and abroad, and they hope that a rebound in US and global growth is coming. In the US, the hope is that tax rebates will sustain consumers until the lagged impact of an easier monetary policy bolsters credit-sensitive outlays, especially housing. The rebound in global equity markets over the past two months − ranging from 12% in the US to more than 20% in Japan and some emerging markets − has gone beyond typical bear-market rallies. Thus, it’s critical for us honestly and objectively to acknowledge and vet the bullish case.
But I want to emphasize downside risks for two key reasons: First, my level of conviction in a darker outlook than what seems to be in the price remains high. And second, markets seem priced to a just-right, muddle-through outcome − one that will limit the damage to earnings and also keep the Fed from tightening. Indeed, the view now in the price dismisses some essential ingredients for our base case as mere low-probability tail risks. Thus I agree with our strategy team that it’s time to take some money off the table, perhaps until the economic fallout gains pace. The bull case has some legitimate props; indeed, we’ve cited some of the factors that underpin it as reasons we expect only a mild downturn. In particular, we have long thought that global growth will hold up relatively well in the developing world; it is primarily the industrial economies that are at risk (see “The Year of Recoupling,” Global Economic Forum, February 11, 2008). And an aggressive policy response will limit the downside risks in the US case. Thus, in the wake of the events of mid-March, our strategy team correctly expected bear-market rallies, as officials ensured that the financial firestorm would not spread out of control, even if the economic fallout had yet to arrive (see “The Eye of the Storm,” Global Economic Forum, April 7, 2008). Several factors seem to suggest that the bull case has legs. First, despite all the headwinds, economies are holding up better than expected. Economic activity in the US, Europe and Japan appears to have accelerated in the first quarter, to 1% (revised), 3%, and 3.3%, respectively. Likewise, non-financial US companies reported healthy earnings (10% year-on-year), and the gains were broad based: 8 of 10 sectors rose, 6 of them by double digits, and 62% of S&P 500 firms surprised positively. In the US, moreover, consumers have slowed spending but haven’t retrenched, capital spending dipped only slightly in the winter quarter, and net exports continue to provide strong support for output. That resilience for US net exports is echoed in domestic demand in many developed and emerging market economies in Asia and Latin America. Indeed, as our global economics team has emphasized, inflation in those economies is by far the bigger problem than growth, and policymakers welcome some slowing to help cap inflation. Looking ahead, tax rebates for US consumers are arriving in bank accounts and mailboxes, promising at least a one-time lift for consumer spending. At this writing, roughly $30 billion has been distributed to about 30 million households since late April, or nearly one-third of the total to be distributed in the current fiscal year. At that pace, the tax rebates will boost disposable income by roughly 14 percentage points annualized in the second quarter, and may well give a lift to spending sooner than we expected. Inflation, moreover, has remained subdued despite the acceleration in food and energy quotes; we estimate that headline inflation measured by the personal consumption price index (PCEPI) ran at an estimated 2.9% annual rate in the first four months of 2008. Investors hope that slower growth will help further to offset inflationary forces. In addition, the credit markets are healing, hinting that tighter financial conditions may not cripple growth. Moreover, the dollar is stabilizing, potentially helping to cool off commodity prices and arrest their assault on discretionary spending power. In my view, however, the downside risks outweigh those positives. Financial conditions are still tightening and are only beginning to affect credit-sensitive demand. In housing, the prospective further declines in home prices and associated rise in foreclosures means that writedowns at financial institutions have further to go. We estimate that, measured by the OFHEO purchase-only index that home prices may decline by another 7-10%, and broader indexes likely will show even larger declines. As evidenced in the Fed’s April Senior Loan Officer Survey, those factors are making lenders broadly more cautious; banks tightened lending standards across all loan categories, not just in mortgages. And as Morgan Stanley Bank analyst Betsy Graseck points out, such lender caution will make it more difficult for borrowers to refinance, implying that bigger losses are coming into 2009 (see Sr. Loan Officer Survey: Less Credit Today Means More Losses Tomorrow, May 8, 2008). Likewise, our credit strategy team thinks that banks and broker dealers in the US and Europe are perhaps two-thirds of the way through the writedowns they will need to take, while provisioning at many banks is only beginning (see A Writedown Writeup, May 13, 2008). Although yield spreads have narrowed significantly in investment-grade debt and leveraged loans, small businesses are reporting that credit is harder to get than at any time since the early 1990s. Moreover, supply-induced increases in energy and food prices are lifting headline inflation and eroding discretionary income. Indeed, the resulting loss in discretionary income from the start of the year nearly offsets coming tax rebates. With crude quotes at $127/bbl and gasoline apparently headed to $4/gallon, we now estimate that the rise in energy quotes between December 2007 and September 2008 will absorb an annualized $85 billion in US consumer discretionary income, or $15 billion more than two weeks ago, while price hikes in food − a much bigger share of consumer budgets − will drain about $50 billion from wherewithal. By comparison, the tax rebates that started going out to consumers at the end of April will amount to $117 billion by year-end. Despite stronger-than-expected April retailing results, the combination of falling home prices, tighter credit, slipping employment, and rising food and energy quotes leads us to think that cautious consumers are likely to spend less of their rebates than many assume. Indeed, those April results may indicate that some strapped consumers spent the checks even before they arrived. The recent plunge in canvasses of consumer sentiment hardly seems consistent with buoyant fundamentals. In addition, cautious businesses, who are beginning to see operating rates slip and profit margins erode, are apt to cut back on capital spending. In that regard, the 180 bp decline in manufacturing operating rates since August (taking out motor vehicles and high-tech industries to remove the influence of the strike in automotive parts) is strong evidence for a weakening in a time-honored support for business investment. Moreover, sources of capex funding are drying up. Slower US and global growth is just starting to hit margins, with a contraction in nonfinancial earnings the most likely outcome. That will undermine corporations’ ability to use cash flow to fund capital spending. Indeed, nonfinancial corporate external financing needs (capex and inventory accumulation less cash flow) had already risen to 4.3% of comparable GDP in the fourth quarter of 2007. With tighter financial conditions curbing their ability to finance outlays, downside risks to companies’ capital spending are rising. The evidence: Revised data now show an 11.1% decline in nondefense capital goods orders excluding aircraft. Finally, US state and local officials are also turning cautious, tightening their belts in several regions. This debate on the fundamentals probably won’t be resolved soon. So what should investors do? For risky assets, I think the bulls’ strongest case is that equity valuations don’t seem stretched, debt seems reasonably priced, and with cash on the sidelines, appetite for risk in debt and equities is substantial. The bear case now is that there is a fair amount of good economic and earnings news in the price, so any downside surprises now pose risks. I see that as a recipe for taking profits. In that context, the muddle-through scenario is the biggest risk to our bearish market call, but it is delicately balanced. In particular, there are a couple of catch-22’s out there for the bulls. If growth fades further, and operating rates continue to slide, that might offer some relief from soaring commodity price hikes. But under those circumstances, operating leverage, pricing power, and profit margins may also crumble. Conversely, if the bulls are right and growth does prove more sustainable, there is a risk that the inflation and interest-rate backdrop will prove significantly less benign than investors believe. Higher inflation and/or interest rates will not be kind to multiples in either US or overseas equity markets.
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Review and Preview
May 20, 2008
By Ted Wieseman | New York
Treasuries posted sizable front end-led losses over the past week that just about fully reversed the partial recovery in rates and the curve seen the prior week after the drubbing the market saw in the second half of April. Economic data released during the week were mostly weak. Slightly better-than-expected underlying retail sales results were the key exception. These figures combined with downside in retail inventories trimmed our estimate of the 1Q GDP revision to +0.8% from +0.9% but boosted our 2Q forecast to -1.2% from -1.6%. The factory sector was extremely soft in April, and early surveys pointed to more weakness in May. Continuing jobless claims extended a string of new four-year highs, pointing to another bad May employment report. While the homebuilders’ survey worsened a bit to continue an extended run of horrific results, housing starts were actually a lot better than expected in April, and while this was mostly because of a surge in the volatile multi-family component, the drop in single-family starts was relatively small. Ultimately, though, upside in starts is not at all good news for the economy, since all it does is drag out the needed correction in bloated home inventories and intensify downward pressure on prices. And inflation was surprisingly benign, both overall and excluding food and energy. Amid all these mostly market-friendly numbers, the only release that really ultimately mattered was the modest upside in retail sales, which contributed to a terrible day for the market Tuesday that accounted for almost all of the week’s net losses. On top of the retail sales results, rebounds in risky markets after their modest negative reversals over the prior week from the huge gains posted since the mid-March lows weighed on Treasuries. Major front end-led losses in Europe that led investors to mostly give up on the possibility of rate cuts – with much better-than-expected 1Q GDP growth in Euroland and significantly worse-than-expected inflation results in the UK key contributors to the sell-offs – also hit Treasuries hard as they persistently opened up well in the red coming out of overnight trading on the back of the selling in Europe through the week. On the week, 2s-10s flattened 13bp to 141bp and 2s-30s 17bp to 213bp, just about fully reversing the 14bp and 18bp steepening moves seen the prior week to leave them back at just marginally above the flattest closes since January hit on May 2. The 2-year yield rose 22bp to 2.45%, the 5-year 16bp to 3.12%, the 10-year 9bp to 3.85%, and the 30-year 5bp to 4.58%. The squeeze at the very short end seen into mid-to-late April is now over after a 26bp rise in the 4-week bill’s bond equivalent yield to 1.85% and a 16bp rise in the 3-month to 1.84%. Energy prices moved to new highs, but just barely as the recent surges greatly slowed down, with June oil up US$0.33 a barrel to US$126.29 and June gasoline US$0.02 a gallon to US$3.22. And other commodity prices were mixed (upside in metals, weakness in a number of agricultural products), and the CPI report benign. But TIPS still had a relatively great week, with the 5-year yield up 7bp to 0.71%, the 10-year 1bp to 1.37%, and 20-year 2bp to 1.96%. On top of the big post-retail sales sell-off and the weakness in Europe, rebounds in risk markets after the prior week’s temporary interruption of the big recovery since mid-March was a major drag on Treasuries through the week. The S&P 500 rallied 2.7% to its best close since January 3 to stand down just 3% year to date. Credit didn’t quite make it back beyond May 2’s best post-January closes, but still had a strong week. The investment grade CDX index tightened 14bp on the week to 91bp and its narrower HiVol subset 37bp to 209bp. The high yield index was 50bp tighter on the week through Thursday’s close at 539bp, and the index traded up marginally further Friday. The leveraged loan LCDX index was 27bp tighter on the week at 340bp midday Friday. The commercial mortgage CMBX market had a very strong week across all the indices, with the AAA, which improved 34bp to 94bp, reaching a new tight since January, while the lower-rated indices also tightened substantially but didn’t quite make it through the May 2 levels. After the across-the-board losses the prior week, the prior familiar pattern reemerged in the subprime ABX market − modest gains by the highest-rated indices, with the AAA up 2.87 points to 58.39, and new lows for the lowest rated, with the BBB- sinking 0.34 points to 7.54. A significantly more hawkish Fed path was priced into futures, with the expected timing of the first hike shifted back in from January to December but with a hike as early as October (seen as likely midweek) priced as a reasonable possibility. Any residual risk of another rate cut was essentially priced out, with the now low-rate July fed funds contract off 2bp to 1.975%. November lost 8.5bp to 2.10%, putting the odds of a hike by the October FOMC meeting at 40%, and January 12.5bp to 2.21%, almost fully pricing in a hike by the December meeting. Eurodollar futures losses were led by the reds (Jun 09 to Mar 10), which plunged 28 to 31.5bp. 3-month LIBOR ticked up 1bp on the week to 2.685%, causing the spot 3-month LIBOR/OIS spread to rise about 1bp to 71bp. There was major volatility in forward spreads during the week. On reports that the BBA would be releasing the results of its investigation into LIBOR-setting procedures early than expected on May 30, they initially blew out. But this was largely reversed later in the week as speculation intensified that the Fed would soon extend the terms of TAF loans from one month to three. For the week, the Jun 08 eurodollar contract lost 4.5bp to 2.665%, Sep 08 11bp to 2.74%, and Dec 08 19.5bp to 2.985%. As a result, the forward LIBOR/OIS spreads out to these dates rose about 2bp to 68bp, 4bp to 69bp, and 6bp to 73bp, though this was well below midweek peaks for all three. Economic data bearing directly on GDP released the past week pointed to slightly better growth in the first half, though we still expect a small net contraction over 1Q and 2Q. The overall ex auto retail sales results for April and the March revision were a good bit better than expected, but the key underlying details were only slightly stronger. Still, they pointed to a small upward adjustment to 1Q consumption and a slightly better trajectory for 2Q. Meanwhile, retail inventories for March were much lower than expected, and February was revised lower. This pointed to an even larger downward adjustment to inventories in 1Q (adding to a big previous downside surprise in wholesale inventories), but with an offsetting smaller reversal in 2Q. Combining these impacts, we lowered our estimate of the 1Q GDP revision to +0.8% from +0.9% (versus the +0.6% advance estimate), but boosted our 2Q forecast to -1.2% from -1.6%. Retail sales fell 0.2% in April, as auto dealers’ receipts declined 2.8%, in line with the plunge in unit sales. Ex auto sales, however, jumped 0.5% on top of an upwardly revised gain in March (+0.4% versus +0.1%). The better-than-expected April result reflected surprising strength in the housing-related components – building materials (+1.9%), furniture (+0.1%), and electronics and appliances (+1.4%). Clothing (+0.7%) and general merchandise (+0.5%) also showed good gains, in line with improved chain store sales results, but there were also sizable upward revisions in these categories in March from modest declines to increases. Given the very weak combined March/April chain store results, clothing and general merchandise sales over this period look suspiciously robust. With a good part of the ex auto upside in April coming from building materials (a category not important for GDP calculations), the key ‘retail control category’ gained 0.3%, as we estimated, though March was revised a bit higher to +0.5% from +0.3%. This pointed to a slight upward revision to 1Q consumption to +1.1% from +1.0%, and the slightly better March starting point boosted our estimate for 2Q to +0.8% from +0.5%. Meanwhile, retail ex auto inventories surprisingly fell 0.4% in March and were revised down to -0.2% from +0.1% in February. Combined with the previously reported much lower-than-expected wholesale inventory results, these figures suggested that the inventory contribution to 1Q GDP growth would be revised down to just +0.1pp from the +0.3pp we saw before these figures, based on the wholesale results and the advance estimate of +0.8pp. We still see an inventory correction being a significant drag in 2Q, but boosted our estimate of the GDP contribution to -0.7pp from -0.9pp. On the inflation front, consumer prices in April were surprisingly benign, but indications of inflation expectations were more worrisome. The consumer price index rose 0.2% in April for a 3.9%Y gain, boosted by the biggest rise in food prices (+0.9%) since 1990. Energy prices were unchanged as a sharp rise in gasoline prices was somewhat less than the seasonal norm. Excluding food and energy, the CPI rose just 0.1%, lowering the annual rate a tenth to +2.3%. The main sources of restraint on the core were a sharp fall in hotel prices (-1.9%), a surprising dip in airfares (-0.5%) and another unusually small gain in medical care (+0.2%). The +1.6% three-month annualized change in medical prices was the smallest since 1972. The key owners’ equivalent rent category gained 0.2%, keeping the annual pace steady at +2.6% for a third straight month, down from a recent peak of +4.3% early last year. Translating these results, we see the core PCE price index rising 0.15%, which would keep the annual rate steady at +2.1%, a bit above the mid-point of the Fed’s two-year-ahead forecast and implicit target of +1.8% but at least not getting worse. Inflation expectations, on the other hand, have been getting worse. The Michigan consumer confidence survey (in which the overall sentiment gauge fell to another 28-year low) showed median 1-year ahead inflation expectations rising to +5.2% from +4.8%, a level not reached since 1982 and not exceeded since 1981. The median 5-year ahead estimate ticked up to +3.3% from +3.2%, a level last matched in 1996 and last exceeded in 1995. TIPS inflation breakevens also continued moving higher, with the benchmark 5-year breakeven up 8bp on the week to 2.41% and the 10-year 8bp to 2.49%. The 5-year spread has now risen 20bp so far this month and the 10-year 22bp so far this month. Data on the manufacturing and housing sectors released the past week were mixed. Industrial production was down sharply in April, and early regional surveys pointed to continued soft results in May. But housing starts posted a surprising jump, and while the upside was all in the multi-family category, the decline in single-family starts was relatively small. Ostensibly, good news for starts is really bad news for the economy, however, as it prolongs the correction of the severe overhang of unsold new homes. Industrial production plunged 0.7% in April, with the key manufacturing gauge down 0.8%, the biggest drop in two-and-a-half years. The continuing American Axle strike contributed to another steep decline in motor vehicle output (-8.2%), with assemblies hitting their lowest level since the 1998 GM strike and before that 1992. Even excluding autos, however, factory output was weak, falling 0.4%. High-tech production posted a relatively small 1.0% gain, and there was broad-based softness among other key sectors, notably machinery, fabricated metals, food and chemicals. The capacity utilization rate fell 0.7 pp to 79.7% and the manufacturing rate 0.8 pp to 77.5%, both lows since late 2004. This left manufacturing cap-u nearly 2 points below the long-term average, pointing to the falling pricing power in the factory sector and likely rising pressures on margins from surging raw materials prices as the ability to pass on these costs fades. Looking to May, the Empire and Philly Fed manufacturing surveys were directionally mixed, but soft overall. An ISM-comparable weighted average of the key activity measures (orders, shipments, employment, deliveries and inventories) showed the Empire survey falling to 49.9 from 51.0 and the Philly rising to 47.2 from 44.0. Our preliminary forecast for the national ISM in May, based on these results, is for a close to unchanged 48.5. We will update our forecast when the rest of the regional surveys are released in the last week of the month. Housing starts surged 8.2% in April to a 1.032 million unit annual rate, but all of the upside was in a 36.0% gain in the volatile multi-family component to 340,000. Single-family starts fell 1.7% to 692,000. This was the 11th straight decline in single-family starts, bringing the cumulative drop since the January 2006 peak to 62%, though the April decline was the smallest in a year. Some significant progress in clearing the backlog of homes under construction was finally made. Single-family completions fell 13.0% in April, though they were still running 14% above the level of starts. We expect another 25-30% drop in single-family starts through year-end in order to bring bloated inventories of unsold new homes down towards more normal levels. The economic data calendar in the upcoming week, which has an early close Friday ahead of Memorial Day Weekend, is very light. Fed news will be more in focus. Vice Chairman Kohn will speak on the economic outlook Tuesday morning. Chairman Bernanke and Vice Chairman Kohn have reportedly committed to one of them, giving a major speech on the economic outlook between FOMC meetings after significant confusion about Fed intentions was at times caused in 2H07 and early this year by their silence amid more active public appearances by other FOMC members. The Tuesday speech by the Vice Chairman appears to be the key intermeeting speech this time. Minutes from the April FOMC meeting will be released Wednesday. In addition to the usual discussion of the April meeting, these minutes will contain updates to the Fed’s economic projections last prepared for the February monetary policy testimony. The only economic data releases of note are leading indicators Monday, PPI Tuesday and existing home sales Friday. Initial jobless claims this week will also cover the survey period for the May employment report: * The index of leading economic indicators should rise 0.1% in April, following outright declines in five out of the prior six months. Significant positive contributions from stock prices, the yield curve, building permits and jobless claims are expected to be partially offset by declines in consumer confidence and the manufacturing workweek. * We forecast a 0.3% increase in the overall April producer price index and a 0.2% gain ex food and energy. Although quotes for a number of energy-related items continued to move higher over the course of the month, the seasonal-adjustment factor appears likely to compensate for such a move at this time of the year. So, the energy component of the PPI is expected to be little changed in April. Meanwhile, with drug prices flattening out following some outsized gains back in January and February and with not much going on in the motor vehicle sector, the core is expected to match the 0.2% rise seen in March. * We expect existing home sales to fall to a 4.88 million unit annual rate in April. With the pending home sales index edging down a bit in recent months, resales are expected to slip another 1% in April. This would put the sales pace just a shade below the 10-year low that was posted back in January.
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Inflation Pressures Ahead
May 20, 2008
By Boris Segura | New York
Despite an aggressive monetary tightening campaign, the central bank of Colombia is in a tough spot. Its measures have included a cumulative tightening of 375bp since April 2006, an increase in reserve requirements and the imposition of capital controls, the last two actions in May 2007. As domestic demand and actual GDP are still growing above potential GDP, we suspect that there are still inflationary pressures in the economy. This fact is likely to complicate Banco de la Republica’s conduct of monetary policy going forward, probably requiring at least one additional rate hike in 2H08. Growth of Potential Output Banco de la Republica now estimates growth of potential output close to 6%. In line with estimates provided in previous inflation reports, we assumed potential GDP growth in a range of 5.0-5.5%. Despite the difficulties associated with these estimations, in principle we tend to agree with the monetary authorities, as investment in Colombia has been rising strongly over the last few years, far outstripping GDP growth. Investment as a percentage of GDP is reaching impressive levels, which bodes well for the expansion of the economy’s production capacity. A higher growth of potential output is likely to somewhat decrease inflationary pressures. As the supply capacity of the economy increases, a given expansion of domestic demand could be accommodated with less inflation and therefore a more relaxed monetary stance. The complication for the central bank is that the economy is likely to show a positive output gap throughout 2008. Even with higher potential GDP growth, and given strong domestic demand, Banco de la Republica is likely to face inflationary pressures throughout the year. According to its own estimates, the output gap will only close by late 2008. Key to lasting disinflation is a meaningful deceleration of domestic demand and actual GDP. We expect the economy to decelerate throughout the year, and expect GDP growth for the year at 5.5%, close to the central bank’s point estimate of 5.2%. But watch out for a similar surprise to the one we witnessed in 4Q07, when GDP growth came in well above the monetary authorities’ and market’s expectation, driven by surging private consumption and a major boost in public works. Probably we are not quite there yet in terms of conclusive evidence of ‘enough’ deceleration of the economy. This is why we infer that the central bank is reluctant to declare victory over inflation, and still talks hawkish. There are some tentative signs of deceleration indeed. As a result of monetary tightening so far, total credit has been slowing down, led by consumer credit. It is showing growth rates in the low 20s, but as a percentage of GDP, is still below levels reached before and during the 1999 financial crisis. Monetary aggregates are showing more subdued rates of growth, which are now close to the expected growth of nominal GDP. Installed capacity is also coming down, but remains at high levels, near the highest in 12 years. A similar observation applies to industrial productions and retail sales. We expect real GDP growth to decelerate during 1Q08 to 6.7% − above Colombia’s potential GDP − but lower than the 8.3% seen at the beginning of 2007 or the 8.1% seen in 4Q07. Growth is likely to be led again by investment, which is likely to contribute as much to GDP growth as total consumption, despite its much smaller share. Net exports are to remain as a drag on GDP, as has been the case since 2004. A Stronger Currency While growth is coming in line with our estimates, we now believe that the Colombia peso is likely to end the year much stronger than we had previously forecast. We are moving our earlier year-end estimates to 1,850 for 2008 versus 2,150 previously and to 1,800 for 2009 (from 2,200 previously). This is a reflection of brighter prospects for Colombian exports and for FDI coming into the country. We now expect current account deficits of 3.6% for 2008 (versus 4.5% previously) and 3.2% of GDP for 2009 (versus an earlier forecast of 4.1% of GDP). Net FDI could top the US$10 billion mark this year and next, allowing further accumulation of international reserves by Banco de la Republica. Recall that it stands ready to purchase up to US$1.8 billion this year, according to its currency intervention guidelines. We have recently highlighted the bright prospects for FDI coming into Colombia (see “Colombia: Abundance of FDI Continues”, EM Economist, April 18, 2008). This new-found attractiveness to foreign investors is driven by dramatic improvements in domestic security, macroeconomic stability and investor-friendly tax and regulatory regimes for new investors. Without taking a directional view on the world economy, Banco de la Republica is more comfortable with the current state of affairs. In its latest inflation report, the central bank does mention the risks of a deeper recession in the US and a faster deceleration in its next two most important trading partners (Venezuela and Ecuador), but still assumes benign terms of trade and a steady flow of foreign direct investment. We also sense that the central bank is more comfortable with a stronger currency. The minutes of its last monetary policy meeting include a somewhat detailed discussion about the causes of the stronger peso. A majority of the board appear to hold the view that a weak dollar and the behavior of terms of trade and FDI mostly explain the peso appreciation. As there are capital controls in place, and therefore little speculative portfolio inflows coming into the economy, the central bank is likely to tolerate a fundamentally strong peso. Don’t expect removal of capital controls soon. As the carry in the Colombian peso is still attractive, the authorities would be reluctant to lift the capital controls. This move would put additional appreciation pressures on the currency. Inflation Path for 2008 Banco de la Republica states that the worst is over in terms of inflation. After its jump early in the year, inflation is headed toward 4.9% at the end of the year, according to the central bank’s latest inflation report. 2008 would be the second year in a row when Banco de la Republica appears set to miss its inflation target. However, we are concerned that the worst is still ahead of us on the inflation front. In particular, base effects for 2H08 are challenging, particularly between June and October, months of very low inflation in 2007. During that period, we actually had food disinflation, which we find difficult to see repeated this time around. In fact, the central bank assumes a major retrenchment of food prices. Again, despite all the difficulties in forecasting food prices, we fear that there is a contradiction between assuming a benign external environment on the one hand and falling international food prices on the other. The central bank only factors in a minor increase in regulated prices. However, in the same report, Banco de la Republica calls our attention to the indexation mechanism in utility rates, which is triggered when cumulative inflation reaches 3%. We also perceive little willingness by the administration to increase its fuel subsidy, in case oil prices don’t come down. In addition, the output gap is likely to remain positive throughout the year, keeping inflationary pressures boiling. These pressures could spill over to an already tight labor market and negatively affect the wage-setting process, which is a concern that Banco de la Republica also raises. We reiterate our inflation estimate for year-end at 5.6%. We still expect a pause in the central bank’s monetary tightening campaign for the remainder of 1H08. As we expect inflation to remain at current levels for the next two months, Banco de la Republica is likely to keep taking stock of the results of the tightening implemented so far and wait for further signs of economic deceleration. However, 2H08’s inflation landscape doesn’t look auspicious, and we still expect at least one more hike in the central bank’s intervention rate to 10%. Bottom Line Even with higher growth of potential output, the Colombian economy is likely to show a positive output gap throughout 2008. Therefore, Banco de la Republica is likely to face inflationary pressures throughout the year, given sturdy domestic demand. We suspect that the worst is not over yet in terms of inflation. Probably we are not quite there yet in terms of conclusive evidence of ‘enough’ deceleration of the economy. This is why we infer that the central bank is reluctant to declare victory over inflation, still talks hawkish and is likely to resume its monetary tightening in 2H08, with at least one more rate hike.
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Real Economy Anomaly Continues
May 20, 2008
By Gray Newman & Luis Arcentales | New York
One of the most glaring anomalies this year has been the disconnect between the US and Mexican economies. Even as the US economy has weakened, Mexico’s economic activity has surprised on the upside (see “Mexico: Three Anomalies”, EM Economist, April 11, 2008). While we expect Mexico’s economy to slow over the course of 2008, we are not likely to get convincing evidence of that trend in the near term. Indeed, with the exception of a weak March industrial production report on May 19, most of the data released in the next month − from 1Q GDP to April industrial production − are likely to confound Mexico watchers in search of a significant slowdown in activity. In the run-up to Banco de Mexico’s next monetary policy decision on June 20, be prepared for a string of data that continues to suggest that the Mexican economy is more resilient than expected. Will the combination of high food-based inflation prints and a resilient economy be enough to prompt the central bank to hike interest rates next month? We don’t think so. But the data should be enough to continue to fuel concerns that a hike might be coming. After all, we believe that the central bank’s May 16 communiqué was an attempt to raise the possibility that its next move could be a rate hike. While the May communiqué continues to highlight the tension that exists between higher-than-expected current inflation and the prospects for a coming slowdown, the central bank moved in a more hawkish direction by arguing that higher food prices in Mexico and around the world represented a “growing” motive of concern. March Weakness At first glance, March’s industrial production report released on May 19 might suggest that Mexico’s economy is finally turning down. We would warn against reading it in that way. March’s 4.9%Y decline is more a reflection of how Mexico’s statistical institute INEGI presents the headline data than a reflection of a true downturn in output. Quite simply, March this year had fewer working days than March of 2007 as Semana Santa trimmed the number of working days by 15%. Actually, it is not as simple as adjusting for the missing work days: when Benito Juarez’s birthday falls in the same week as Semana Santa, as was the case in March 2008, production tends to be even lower, with many workers taking off the ‘bridge’ days between the two holidays. March’s one-off 4.9% drop has already been well documented in other series. Auto production showed a sharp 9.8% decline in March, only to soar by 28.4% in April. March’s fewer work days also help explain why imports were weak: consumer goods imports (ex gasoline) fell by 5.4%; we expect to see a reversal when the April trade data are released just as we expect industrial production to soar in April − a release set for June 17, just days before the central bank will next meet to decide on any changes to monetary policy. Of course, the April ‘rebound’ is just as suspect as the March ‘decline’ and leaves us doubting that greater clarity will arrive until May data begin to be released in late June and July. Of course, seasonal adjustment techniques are supposed to correct for floating Semana Santa as well as the leap year’s impact on February data. However, when Benito Juarez’s holiday is added, along with new data series (released during the past month, but only back as far as 2003), it is not hard to see why statisticians are having a difficult time cleaning up the data. For example, February’s 5.8% jump in monthly GDP might look strong, but Mexico’s statistical institute concluded that it was consistent with an economy contracting at a 22% annualized rate. Just as March’s weak IP showed an upturn once seasonally adjusted, March’s monthly GDP is likely to show a meaningful bounce. We would warn against making too strident of a conclusion in either direction. Mixed to Positive Signals That said, the majority of high-frequency data – from retail sales to trade and investment – suggest that economic activity is running at a good pace without signs of a sharp slowdown as seen in the US. Investment spending jumped 16.9% in February – the second consecutive double-digit gain – and preliminary data such as March capital goods imports (+26.0%) point to further good momentum on the investment front. Once March and April retail data are averaged from the association of most of Mexico’s leading retailers (ANTAD), the series suggests that retail sales grew 8.1% during the two months, a modest slowdown from the 10.2% during the first two months of the year and 8.7% in 4Q07. And the prospects for important fiscal stimulus above and beyond what has been budgeted should not be underestimated. With the Mexican oil mix running above US$100 per barrel − more than double the US$49 per barrel 2008 budget estimate – the public sector should have sizeable additional resources to spend this year. Indeed, additional stimulus could amount to as much as 2% of GDP in 2008. Meanwhile, in 1Q08, public sector physical investment rose by 48.8% in real terms as part of an ambitious investment budget of roughly 5.0% of GDP. Labor Pains What may seem surprising is that while Mexico’s export and industrial production data have held up fairly well, job creation continues to weaken. The newly revised employment data from Mexico’s Social Security Institute, which we use as a proxy for formal employment growth, not only showed that job creation has been lower than the previous data suggested, but also that the pace of the slowdown in job growth seems to have quickened in recent months. In the first four months of the year, formal job growth has been running at 3.3%, compared with a 4.2% rate during all of 2007. And unlike the strength in manufacturing production, formal job growth in the manufacturing sector has turned negative, with permanent positions being lost at a rate of -2.0% in April and -1.6% for the first four months of the year. In contrast, measures of wage growth remain largely unchanged: wages (excluding benefits) grew on average of 4.4% in April, matching the 4.4% average for the first four months of the year − in line with the 4.2% increase on average in 2007. Meanwhile on the confidence front, the evidence is mixed. Consumer confidence has been on a steady downtrend since last year and now stands at the lowest seasonally adjusted level since 2005. However, we suspect that some of the damage earlier this year may be reversed if the US recession turns out to be shallower than first thought. The central bank’s survey of confidence among a group of economists polled each month tends to match up with the consumer confidence survey with one important difference: swings in the group of economists tend to be much more pronounced than among consumers. The more volatile economists’ survey is interesting: in recent months, it has suggested that we are seeing a modest uptick in confidence − an uptick that we expect to see in the consumer survey in the months ahead. Bottom Line Aside from a weak but statistically suspect March industrial production report, look for more good news from Mexico’s real economy. No sooner will the market be digesting the weak March industrial production report than the authorities will be releasing a strong 1Q GDP report which we think could reach 3.5% (the 1Q GDP report is set for May 22). And in the weeks leading up to Banco de Mexico’s next monetary policy meeting set for June 20, a host of data points showing a (somewhat exaggeratedly) strong April can be expected. In the coming months, we expect Banco de Mexico to stay torn between an unexpected rise in current inflation and its own forecast of the upcoming slowing in the Mexican economy. If the upcoming slowdown does not materialize as the central bank expects − because of the strength of Mexican exports to non-US destinations or because of much larger oil windfalls − Banco de Mexico may conclude that the balance of risks on the inflation front has shifted. While we are not revising our rate scenario to include a hike, we wouldn’t be surprised to see the debate continue to move in that direction.
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