Review and Preview
May 27, 2008
By Ted Wieseman | New York
After a lot of volatility along the way, particularly for such a light news week, Treasuries ended the past week close to unchanged. Early in the week, the market staged a solid rebound from the prior week’s big front-end-led sell-off, but as oil spiked higher in an increasingly disorderly manner, inflation fears drove a sharp reversal Wednesday and Thursday, before a sizable rebound off the lows in Friday’s shortened trading session to end the week. Notably, the flat performance of Treasuries on the week came despite significant losses across risk markets, breaking at what had been a consistently strong negative correlation for some time. This relationship held strongly during the early week rally, as the bond market actually received an odd lift from an ugly PPI report, responding more to the resulting stock and credit weakness than to the data themselves. It was only when the huge spike in oil hit Wednesday that broadly based weakness was seen across risk-free and risky markets. The stagflationary fears driven by out-of-control oil prices were evidently seen as bad news for most asset classes – if only for a couple of days, as Friday’s sizable Treasury market rebound was supported by significant weakness in risk markets as oil prices continued moving higher. It remains to be seen whether the broadly based weakness across markets seen Wednesday and Thursday was just an anomaly and Treasuries will continue the resumption of trading inversely to risk markets or whether all markets will again come under pressure if oil prices continue surging higher. In addition to oil, major weakness in Europe, where 2-year yields surged about 25bp in both the UK and the Eurozone, also weighed on Treasuries through the week, as investors largely gave up on the possibility of rate cuts based both on country-specific economic and monetary policy news and the generalized inflation fears that intensified across the globe.
For the week, benchmark Treasury yields ended little changed, with the 5-year underperforming a bit, but only after the 2-year yield moved back and forth an average of 10bp a day. This didn’t net to much, though, with the 2-year yield dipping 2bp on the week to 2.425%, the 5-year rising 1bp to 3.125%, and the 10-year and 30-year each declining 2bp to 3.83% and 4.55%, respectively. The dominant story of the week was oil, with the front July contract jumping more than US$5 a barrel on the week to over US$131. Upside in longer-dated contracts was of at least as much concern, with the furthest out Dec 16 contract up US$10 barrel to almost US$137. This upside helped TIPS extend their recent outperformance. This was most pronounced, of course, at the short end, where carry should be hugely positive in coming months, but the benchmarks also did well, with the 5-year yield flat at 0.71%, the 10-year down 5bp to 1.32%, and the 20-year down 6bp to 1.90%. The 5-year/5-year forward breakeven based on the benchmark issues rose 5bp to 2.61%, having now risen about 25bp since the new 5-year was issued in April. Risk markets were mostly substantially softer on the week, and while this weakness drove sizable rallies in Treasuries Tuesday and Friday, the inverse relationship at least temporarily broke down Wednesday and Thursday when Treasuries and risk markets traded off together in dismay at the shocking spike in oil prices Wednesday. At the time of the early bond market close, the S&P 500 was down about 3.5% on the week and on pace for its lowest close since mid-April. Credit spreads widened sharply on the week, also to their worst levels since around the middle of April. In early afternoon trading Friday, the investment grade CDX index was 20bp wider on the week at 111bp (up 25bp from the recent best close of 86bp on May 2) and its HiVol subset was 37bp wider at 246bp. The high yield index was 42bp wider through Thursday, and the index was trading down another half point Friday. Other markets were weaker, but have held up relatively better recently than stocks or the corporate credit indices. The leveraged loan LCDX index was 25bp wider on the week at 362bp as of midday Friday, which would be the worst close since May 9. The now off-the-run series 4 commercial mortgage CMBX market (the series 5 began trading Thursday) widened significantly on the week, but also only to about the highs in two weeks. The AAA index widened 9bp to 103bp and the AJ index 33bp to 338bp, up from their best recent closes hit Monday of 88bp and 285bp, but still a good bit better than the wides seen this month on May 9 of 128bp and 411bp, respectively. The subprime ABX market was down significantly across the board on the week, but mixed on a slightly longer view. The AAA index fell 2.49 points on the week 55.90, a low since May 8 and still somewhat better than intraday lows that nearly broke 50 a couple months ago. All the lower-rated indices − AA (15.00), A (9.88), BBB (7.96) and BBB- (7.04) − however, ended the week at all-time lows. Although there was a lot of volatility through the week that tracked the sizable back-and-forth moves in Treasuries, ultimately there was no meaningful change in Fed expectations on the week, as a speech on the economic outlook from Vice Chairman Kohn and the release of the minutes from the April FOMC confirmed that the Fed is firmly on hold for now, not that there was any doubt about that anyway. The low-rate July fed funds contract was unchanged at 1.975%, while November (which through Thursday had moved to price in an October rate hike, but thought better of it Friday) lost 1bp to 2.11%, January dipped 1.5bp to 2.225%, and February was flat at 2.42%. Against this steady near-term Fed outlook, 3-month LIBOR fell 5bp to 2.65%, causing the 3-month LIBOR/OIS spread to decline 6bp to 65bp, low in two months and down from a recent peak of 90bp on April 21. Forward spreads also saw modest further improvement, as the Jun 08, Sep 08 and Dec 08 eurodollar contracts all posted small gains, reducing forward spreads to those dates to around 64bp, 67bp and 69bp, respectively. It was a light week for economic news. The most notable release was a worse-than-expected PPI report, which showed significant upside in pipeline inflation pressures continuing in April even before the latest surge in energy prices has had time to be reflected in the numbers. The overall producer price index rose 0.2% in April for a 6.5%Y gain, restrained by a slight decline in energy prices (-0.2%) and flattening out in food (0.0%) after a big gain last month. Wholesale gasoline prices were up significantly, but a good bit less than the seasonal factors we were looking for, resulting in a 4.6% seasonally adjusted decline that offset upside in utility costs. The gasoline seasonals moderate significantly in May and then swing the other way in June, so unless prices turn down, this decline will be reversed in coming months. The CPI has a similar pattern, so if gasoline prices continue moving higher into the summer, as seems very likely at this point, there will be major upside in seasonally adjusted headline CPI in the months ahead. Meanwhile, the core PPI rose a significantly higher-than-expected 0.4%, a third significantly elevated reading in the past four months, lifting the year-on-year pace to +3.0%, a high since 1991. Part of the upside in the core came from cars (+0.4%) and light trucks (+1.3%). Auto prices in the PPI are highly volatile and, in our view, not reliable, so we generally ignore them. Even excluding motor vehicles, however, the core rose 0.3%, extending a recent string of elevated readings, with more upside in recently surging prescription drug prices along with significant gains in alcoholic beverages, furniture and some types of capital goods. Early stage readings were again ugly. The core intermediate surged another 1.2% on top of a 1.1% gain last month, two of the biggest monthly increases since 1980. The core crude spiked 7.9%, one of its biggest gains ever, with a 32.2% surge in iron and steel scrap the key contributor. The week’s other notable release was existing home sales, which pointed to some early signs of stabilization in the housing market. Sales fell 1.0% in April to 4.89 million units annualized and have now been little changed on net over the past six months as a steep drop in prices, with the median sales price down 8%Y in April, and decline in average mortgage rates have lifted housing affordability to the upper end of the historical range. The supply of unsold homes jumped to 11.2 months from 10.0, a high since 1985. While the upside this month was largely seasonal − the number of homes for sale used in this calculation is not seasonally adjusted and usually rises sharply in April − inventories still remain badly out of balance relative to a more normal 5 to 6 months. In addition to continued stabilization in sales, we estimate that another 25-30% drop in single-family starts will be needed to bring inventories down to more balanced levels by the first part of next year. The economic calendar is quite a bit busier in the upcoming shortened week, although it won’t be until the following week that the next round of key data are out as the initial round of May numbers are released, which at this point we expect to be soft. We’ll update our forecast based on the results of the remaining regional surveys in the coming week, but our preliminary forecast for the May ISM is for little change at a modestly soft 48.5. Early indications are that motor vehicle sales will show only a marginal improvement from the horrible 14.4 million unit sales pace reported in April. And with underlying claims results continuing to deteriorate, we look for a 65,000 drop in non-farm payrolls, which would be a fifth-straight decline in overall jobs and sixth straight for private sector payrolls. There are again a number of Fed speakers in the coming week, though following Vice Chairman Kohn’s remarks and the release of the minutes from the April FOMC meeting, the Fed’s firmly on hold policy is clear while it waits for downside risks to growth and upside risks to inflation amid significant uncertainty about the outlook to be clarified, so upcoming speeches are unlikely to shed any new light. Note that Chairman Bernanke will be speaking Thursday but he will merely be repeating his speech from May 13 on Fed liquidity measures. Supply will be a significant focus in the coming week, with the US$30 billion 2-year auction Wednesday and US$19 billion 5-year auction Thursday. These sizes were surprisingly unchanged after a series of increases, so it looks like relatively more of the Treasury’s currently heavy financing needs as tax rebate checks are distributed and the weak economy causes the underlying budget picture to deteriorate will be done through bill issuance. A number of primary dealers end their fiscal quarters in the coming week, which will likely have a significant negative impact on market liquidity. Notable data releases in the coming week include new home sales and consumer confidence Tuesday, durable goods Wednesday, revised GDP Thursday and personal income and spending Friday: * We forecast April new home sales of 540,000 units annualized. Sales of newly constructed residences posted significant declines in both February and March even though the NAHB survey indicated that the current pace of sales was holding reasonably steady. So we look for a modest 2.7% rebound in April and expect the underlying sales pace to show signs of bottoming in the 525,000-550,000 range over the next few months. * We expect the Conference Board’s measure of consumer confidence to fall to 58 in May, which would be a 16-year low. The ongoing surge in gasoline prices – and accompanying media coverage − should contribute to some a further deterioration in sentiment. This would be consistent with the slippage seen in both the University of Michigan and ABC polls for early May. * We expect durable goods orders to fall 2.5% in April. Company reports point to a pullback in the volatile aircraft component following solid gains in both February and March. Also, weak demand for new motor vehicles, together with a strike at a key supplier, has triggered significant production cutbacks, and this is likely to be reflected in a further pullback in bookings for autos and auto parts. Otherwise, the results of the ISM survey point to another modest decline in core order activity. So, we look for a modest dip in non-defense capital goods excluding aircraft. Finally, core shipments are expected to edge down 0.5%, while inventories should show a more modest gain than in recent months (+0.3%). * We expect 1Q GDP growth to be revised up to +0.8% from +0.6%, with the combined effect of modest upward adjustments to net exports, non-residential construction and personal consumption more than offsetting a sharply lower result for inventories. Indeed, relative to the initial report on 1Q GDP, the inventory contribution is expected to swing from a +0.8 percentage point contribution to just +0.1. * We expect both personal income and spending to be up 0.2% in April. The labor market report pointed to very sluggish growth in wages and salaries during the month of April. So, we look for a more modest gain in overall income than seen in recent months. Meanwhile, a steep fall-off in vehicle sales should help to restrain spending. Finally, our translation of the CPI and PPI data suggests that the headline PCE deflator will be up 0.3%, with the core rising 0.2% and the year-on-year rate ticking up to +2.2%.
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Growth Cycle – At the Crossroads
May 27, 2008
By Chetan Ahya | Singapore & Tanvee Gupta | India
After three years of above-trend growth, India is now facing challenges from an adverse global macro environment that has increased the risk of pushing the country’s growth below sustainable levels. Higher oil and other commodity prices have heightened inflation concerns. The depreciation of the rupee is likely to add to the inflation pressure. Political tolerance for inflation is low considering that we have 10 state elections over the next 12 months, followed by a general election that is due to be held by May 2009. Apart from the challenges emerging from the global environment, we believe that the economy could also suffer from potential continued risk aversion in the global financial markets, which has already affected the corporate sector’s ability to raise funds from the international markets. We believe that the final outcome of the current growth cycle will depend on how the global factors shape up. Analysing the Recent Growth Trend We group India’s last few years of growth development cycle into three phases: (1) a prolonged period of below sustainable growth – 1998 to 2003; (2) acceleration to overheating zone – 2004 to 2007; and (3) reverting back to sustainable growth rates – 1H08. We believe that the underlying sustainable growth rate is currently 7.5-8% – the level at which the risk of overheating is low. However, we believe that there is now an increased risk of growth dipping below this sustainable growth level due to an adverse global macro environment. In the following paragraphs, we describe each of these phases in detail and bring up the parallels between the current growth cycle and the 1993-96 cycle. Phase I – Prolonged Below-Trend Growth (1998-2003) During the five years ending F2003, India’s GDP grew at 5.4% due to a continued adverse global environment. During the first half of this five-year period, the emerging market growth environment was affected by the Asian financial crisis, the Long-Term Capital Management (LTCM) crisis and the Russian debt crisis. In addition, the tech bubble collapsed and 9/11 only added to the risk aversion in the global financial markets. This prolonged period of risk aversion resulted in reduced capital inflows into emerging markets. While India’s underlying sustainable growth potential was higher at 6-6.5%, the global environment restrained actual performance. The continued period of low growth created excess capacity. This was also reflected in the current account moving to a surplus of 2.3% of GDP in F2004 (the 12 months ended March 2004) from a deficit of 1.3% of GDP in F1998. This was an unprecedented swing in the current account balance. Phase II – Acceleration to Overheating Zone (2004-07) The timing of the acceleration in India’s GDP growth from 2004 coincided with a resurgence in the overall emerging markets growth trend. The positive trigger came in the form of an increase in global risk appetite from 2003 onward and an increase in capital inflows in emerging market economies. One of the key drivers of this phase was the prolonged low real interest rates in the US over mid-2001 through 2004. As per the IMF, total private capital inflows to emerging market economies increased six-fold to US$629 billion in 2007 from US$102 billion in 2002. Following this trend, total capital inflows into India increased to US$98 billion in 2007 from US$12 billion in 2002. We believe that these large capital inflows played a key role in boosting India’s growth cycle to above-sustainable levels. Capital inflows resulted in a sharp fall in real interest rates, boosting domestic demand. We believe that while India’s underlying sustainable growth rate in 2004-07 was in the 7-7.5% range, actual growth averaged 8.8%. While the structural factors in the economy – particularly the strength of the corporate sector – played an important role in the acceleration of growth, we believe that cyclical global factors were also significant contributors. In the initial phase of growth acceleration above the sustainable levels, the economy did not overheat due to a high level of excess capacity at the start of the cycle. However, we believe that the economy had started to move towards an overheating zone around the end of 2005. Phase III – Reverting to Potential (1H08) Policymakers allowed the phase of above-trend growth to last for a little longer despite early signs of overheating. While the RBI’s policy statement first highlighted the concerns of demand-side pressures in July 2006, and lending rates increased further from 2Q06, the fact that the starting point for lending rates was relatively low enabled demand growth to remain strong in 2006. Some signs of overheating included a sharp rise in property prices (100-300%) in top cities in the country, a widening trade deficit, a widening current account (excluding remittances) and credit growth sustained at 30%-plus for three years. Until 4Q06, policymakers took comfort from the fact that inflation was still within the comfort zone. At the time, we argued that an increased level of trade openness meant that inflation pressures would take a little longer to emerge and that lending rates probably needed to move faster. However, a sustained period of overheating resulted in inflation moving above the comfort zone of 5-5.5% from November 2006, forcing the central bank to pursue aggressive tightening to buy insurance against further risks from demand-side pressures. The RBI’s aggressive tightening resulted in prime lending rates spiking 175bp to 13% in a span of five months (December 2006-April 2007). The lagged impact of RBI’s monetary policy actions brought GDP growth down to an estimated 7.5% in 1Q08. Indeed, industrial production growth decelerated even more sharply to 5.8% during the quarter ended March 2008, from a peak of 13.6% during the quarter ended January 2007. In our view, if banks maintain their prime lending rates, GDP growth will likely continue to weaken. The prolonged period of weaker consumption growth is bound to weigh on the business capex cycle. Risk of Growth Dipping Below Potential Trend (2H08-??) While growth has already reverted to more sustainable levels, the global macro environment could force a further slowdown. Just as during 2005-07, when strong positive global factors supported India’s growth above its then-sustainable growth trend, negative global factors are now threatening to pull its growth below the potential. The most important adverse factor is the global commodity price trend. While India is self-sufficient in steel and aluminum, it is heavily dependent on imported copper (concentrate), coking coal, edible oils and, most importantly, crude oil. Even for commodities – where the country is self-sufficient – market-oriented pricing means that some indirect pressure on domestic pricing of global commodity products is inevitable. This is evident in the recent spike in prices for domestic steel, iron ore and certain food products. Rising oil prices continue to be a big challenge for the country. India imports about 70% of its crude oil and refined products requirements. A roughly US$10/bbl increase in crude oil prices results in higher imports and trade deficit and a current account deficit of US$7 billion (0.6% of GDP). With the government having increased domestic fuel prices by only 26% for petrol and 34% for diesel (average for the country) over the last four years – during the period in which international crude oil prices have shot up about 225% to US$129/bbl currently – the subsidy burden continues to spike. In F2009 (the 12 months ending March 2009), if crude oil prices average US$120/bbl, we believe that the oil subsidy (including the burden on oil companies) will increase to US$40 billion (3.3% of GDP). As per our Oil and Gas analyst Vinay Jaising, domestic oil products are marked to an implied average of US$65/bbl. If the government were to hike domestic product prices to market, inflation would rise by about 6.9 percentage points. Even without the increase in domestic oil prices, the rise in other commodity prices has already pushed inflation to close to a three-and-a-half-year high of 7.8% during the week ended May 3, 2008 and the fiscal deficit (including off-budget expenditures) to a five-year high. The depreciation of the rupee will only add to the inflation pressures. The inflation challenge is holding the central bank back from initiating much-needed policy rate cuts. Higher inflation will slow spending by low- and middle-income groups. The increased global risk aversion and shrinking leverage of the financial institutions will also affect the international funding plans of Indian companies. Capital inflows into EMs and therefore into India could also slow. The confluence of these adverse factors has increased the downside risks to the growth trend. Some Similarities to the 1993-96 Cycle To be sure, sustainable growth in the current cycle is much higher than in the previous cycle, and the Indian corporate balance sheet is in a very different shape today than it was in the 1993-96 cycle. We believe that the trough of the growth is now likely to reach the lows it touched during 1997-98. However, the current cycle does remind us of the 1993-96 cycle in many ways. As in the current cycle, in 1993-96 a favorable emerging market environment accentuated the acceleration in the growth trend to the overheating zone. Weak capacity growth (particularly in the infrastructure sector) relative to strong domestic demand growth pushed inflation to double-digit levels during 1994-95. The spike in inflation concerned the policymakers, particularly as general elections were scheduled for 1996. The high level of interest rates slowed consumption growth. We believe that we are in a similar state now. Growth has already slowed, and the global macro environment will determine the final outcome. In 1993-96, the global outcome unfortunately turned extremely unfavorable. The Asian crisis and resultant risk aversion in the global financial market prolonged the down-cycle. Similarly, the current adverse global macro environment is increasing the risk of the growth trend dipping below the current sustainable growth of 7.5-8%. Longer-Term Solution Lies in Managing Supply Side Better For an emerging economy like India with a rising working population and a large unemployed workforce, limitations on potential growth are determined by the pace of reform in the economic environment, which allows resources to operate productively. Although the government has been initiating reforms, we do not believe that the pace of implementation is strong enough to sustain the recently attained 9-9.5%. Unlike China, India’s response to productive capacity creation has tended to be weak, i.e., growth in productive capacity has been relatively slower than growth in demand. This has resulted in India’s absorption of liquidity for productive capacity being less than optimal. The skewed trend is due to the unsatisfactory performance of the public sector. We believe that a commensurate rise in the supply side is critical to ensure a sustained acceleration in growth to 9%. The government needs to implement measures to accelerate the supply-side response by investing in infrastructure, implementing labor reforms, improving the management of government finances and strengthening the administrative framework. With infrastructure being the most important hurdle, in the following paragraphs we elaborate on this issue in detail. Overall, investment growth has been strong, but imbalances – in terms of allocation to infrastructure versus private business capex – are challenging the sustainability of this high growth. This imbalance in investments is affecting overall productivity growth. For example, private corporate investments rose to 14.5% of GDP in F2007 from 5.4% in F2002, but infrastructure investments remained low at 5% of GDP in F2007, albeit higher than GDP of 3.8% in F2002. If we take China as a benchmark, India needs to invest at least 7-7.5% of GDP in infrastructure, excluding real estate, to sustain 8% GDP growth without overheating. Over the last 10 years, China has invested, on average, about a quarter of its total investments in infrastructure. In India, rapid growth in demand for infrastructure over the past five years and a less-than-proportionate rise in infrastructure spending have meant that capacity utilisation in electricity generation, seaports and major airports is at maximum levels. For the tenth five-year plan (F2003-07), the government targeted 41,000 MW of capacity addition. However, the actual addition was only 18,400 MW. This delayed supply response meant that the peak electricity deficit increased to a nine-year high of 16.6% during April-February 2008, forcing supply outages in various industrial areas. Seaports’ capacity utilisation increased to over 90% as of early 2008 from 84% in F2002. In the airport segment, the two key airports of Mumbai and Delhi (accounting for 41% of domestic air passenger traffic) have significant capacity constraints because of limited landing slots, congestion during peak hours and a lack of other infrastructure facilities. A complex set of factors is causing this delayed response in infrastructure development. A weak regulatory framework (particularly in the case of electricity), land acquisition problems, stretched capacity of domestic construction companies and the lack of available equipment in certain areas have been the major impediments. This imbalance in investments results in overall ‘effective’ capacity growth being weaker than total investments would imply. The bottom line is that while, theoretically, India’s potential economic growth can be higher at 10%-plus, as in China, we think that the slower-than-warranted response from policymakers to create the infrastructure supply is restraining ‘practical’ potential growth. The imbalance in investments is one of the key factors behind the recent overheating of the economy. This overheating, in turn, forces the central bank to pursue a relatively tighter monetary policy, lifting the cost of capital and implying a lower GDP growth rate. Although the government policy response is improving, we believe that the current policy response for infrastructure is not strong enough to lift the sustainable GDP growth to 9.0-9.5% in the near term.
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