Sunday, February 8, 2009

Weekly Focus: A Little Light in all the Dark

The past week offered continued mixed news but recently the surprises have been more balanced rather than systematically on the downside. A positive surprise came from the global PMI, which is one of the best indicators of growth developments. The data showed an increase in most countries following the very steep decline in the second half of 2008. The rise in PMI has come sooner than expected, although we have been looking for this to happen in the US during the first half of 2009 (see Research USA: Manufacturing recovery ahead). The development offers hope that the massive decline in production is coming to an end. The levels of PMI still point to falling production but the pace at which it is falling seems to slow down.

Commodity prices have also stabilised recently which points in the same direction of bottoming in production. Metal prices are very cyclical and after a steep fall in the past six months they now seem to have found a base.

The past week also offered more positive news out of China (see Flash Comment: Signs of the economy bottoming out). First, the Chinese PMI data showed a decent further rise in January. Second, lending growth has risen strongly recently suggesting that investment spending is picking up. Third, shipbrokers have seen signs of stronger freight demand which has also led to a rise in the Baltic Dry Freight index during the past week, albeit from very low levels. A recovery in China is very important for stabilising the world economy and hence this is encouraging news.

There is no doubt that 2009 will be a very difficult year and it is too early to draw any firm conclusions. However, the recent signs are at least on track with the expectation of a gradual recovery and thus provide hope that the global economy can recover once the massive stimulus works its way through.

Euroland: Worst growth data ever

So just how bad is growth in Euroland? The coming week will give us an answer with the publication of GDP data for Q4. Judging from leading indicators and expectations, the situation is dire. The financial crisis kicked in big-time in Q4, exports have collapsed, investment is non-existent, and private consumption is slowing sharply, hit by credit tightening, falling asset prices and, not least, fears of being made unemployed as a result of the crisis.

The outcome is expected to be a third successive quarter of negative growth, and we would not be surprised to see contraction of 1% relative to Q3. This would be by far the worst growth in Euroland's history. However, there is a fair amount of uncertainty about the figures, due not least to the stock component. There is scope for a surprise on the upside if businesses produced large quantities for stock as we saw in the Q4 GDP figures for the USA. This might, for example, be the case if businesses were caught napping by the sharp drop in demand. That would make growth less negative in Q4, but would come at the cost of weaker growth in the current quarter instead. However, we will only be getting the headline data in the coming week and none of the underlying components from the supply balance sheet.

We expect Q4 to be the nadir of the current economic downturn, but the outlook for 2009 is still very bleak. Q1 threatens to be almost as bad as late-2008, and the earliest we can hope for positive growth is H2 this year. Nevertheless, there is a risk of Euroland, as a whole, having to go through five or six quarters of negative growth before output bounces back.

The overall GDP figures for the whole of Euroland will be preceded by growth data for the individual member states. These are expected to be very weak right across the board. For example, there is the prospect of an even bigger drop in GDP in Germany than after reunification!

Key events of the week ahead

  • Thursday: Q4 GDP figures for Spain and Belgium.
  • Friday: Q4 GDP figures for France, Germany and Euroland as a whole.

Switzerland: Sharp downturn in labour market

The unemployment figures for January provided no relief from the rapid deterioration in the Swiss labour market since the autumn. Seasonally adjusted unemployment climbed to 2.9%, which is 0.4 percentage points higher than last summer's low. Although Swiss unemployment is still modest by international standards, the acceleration in unemployment and decrease in employment are worrying, and with the KOF leading indicator at record-low levels, continued correction in the labour market has to be expected. This will naturally have an impact on private consumption, and we agree with the consensus that Thursday's figures will show consumer confidence down to levels last seen in 2002.

On the other hand, dwindling demand means reduced pressure on prices, and this, together with plummeting global energy and commodity prices, has caused Swiss inflation to fall back rapidly. The consensus expectation for Tuesday's CPI data is a decrease of 0.5% m/m in January, taking year-on-year inflation down to just 0.6%. As in other Western economies, the steep slide in prices has led to talk of the risk of deflation, but the Swiss National Bank (SNB) has said repeatedly that it still considers these sharp falls in prices to be a temporary phenomenon and that there is currently no reason to fear deflation.

The past week has also seen continued recovery in the money market. The 3M LIBOR is currently at 0.52%, which means that the SNB has effectively achieved its current monetary policy target. With short repo rates just over 0%, the options for further monetary policy stimulation remain limited, and we expect to see more alternative monetary policy measures from the SNB in the coming months. The CHF weakened slightly against the EUR during the week, and EUR/CHF is now trading back around 1.50. However, the interest rate spread to Euroland is still narrowing, and with equity markets largely moving sideways we do not expect to see the EUR/CHF breaking markedly above 1.50 in the short term despite the higher risk premium on the CHF due to the risk of intervention.

Key events of the week ahead

  • Tuesday, 07.00 CET: UBS publishes its Q4 results.
  • Tuesday, 09.15 CET: CPI for January.
  • Wednesday, 07.00 CET: Credit Suisse publishes its Q4 results.
  • Thursday, 07.45 CET: SECO consumer climate index.
  • Friday, 09.15 CET: PPI for January

USA: First positive signs and more help on the way

The ISM index for the manufacturing sector climbed in January for the first time since the Lehman bankruptcy last September. The underlying data in the ISM report were positive and suggested that the balance between inventories and demand in the manufacturing sector has improved. This is the first sign that the US manufacturing industry is set to stabilise after being hit hard by the combined shock of the credit crunch and the sharp downturn in demand. We expect the negative impact of the credit shock to subside now and the ISM to rise further.

Treasury secretary Timothy Geithner is expected to present a substantial new rescue plan for the financial sector in a speech on Monday. Several different options have been considered. These include a ‘bad bank' to take over the toxic assets on banks' balance sheets. An insurance model has also been floated, where the state covers losses on these toxic assets above a certain level. The plan will probably also include closer regulation of the financial sector and further help for homeowners at risk of foreclosure.

The House of Representatives has approved its version of the fiscal policy stimulus package, and the Senate is working on getting its own version - which will probably run close to USD1trn - in place. The focus in the coming week will be on whether the two chambers of Congress can agree on a combined solution before breaking for their winter recess on 13 February. The most interesting data due out during the week are retail sales for January. We expect an overall drop of 1.0% m/m due to a sharp slide in auto sales, while we expect retail sales ex autos to fall by a more moderate 0.4% m/m. There will also be a number of speeches from FOMC members during the week, the most important coming on Tuesday when Bernanke testifies to a House panel on the Fed's measures to unlock the credit markets.

Key events of the week ahead

  • Monday: Treasury Secretary Geithner to announce financial rescue plan.
  • Tuesday: Bernanke to testify on Fed programmes and Treasury Secretary Geithner to testify on TARP.
  • Thursday: We expect retail sales to fall by 1.0% m/m in January overall and by 0.4% m/m ex autos.
  • Friday: We expect the University of Michigan consumer sentiment index to fall from 61.2 in January to 60.0.
  • Keep an eye on the passage of the stimulus package through Congress.

Asia: Brighter outlook for China

Economic data increasingly suggest that the Chinese economy is bottoming. Manufacturing PMIs rose in January - for the second consecutive month - on improving domestic orders (see Flash Comment - China: Signs of the economy bottoming out). The pick-up in orders could reflect the substantial fiscal easing beginning to have an impact and inventories having been reduced to more sustainable levels. However, there are also other signs of stabilising Chinese growth. Credit growth accelerated sharply at the end of 2008, and according to press reports the January lending data due out in the coming week should show accelerating credit growth - which normally signals accelerating investment. Also, the prices of a number of Chinese metals have stabilised and even edged up a little since the new year after plummeting in H2 08.

During the past week, the good news on the economic front has dampened speculation that the Chinese government would allow the CNY to depreciate. On offshore markets, 1Y CNY forwards have strengthened by 2.1% to 6.92 against the USD. However, this implies that the market still expects the CNY to weaken by about 1.2% relative to the current USD/CNY spot rate of 6.84. We expect the CNY to trade more or less sideways against the dollar in the short term, and to strengthen to around 6.60 one year from now as the outlook for the Chinese economy brightens. Therefore, the CNY looks cheap in forward markets, in our view.

In Asia, attention will mainly focus on the Chinese indicators due out in the week ahead. As mentioned, we expect lending growth in China to have accelerated further to more than 20% y/y in January. The coming week will also see the release of foreign trade data for January. The South Korean trade data for January already published suggest that Chinese exports will weaken sharply once again. That said, the January numbers are clouded in uncertainty, as - unlike last year - the Chinese New Year fell in January this year and not in February. This reduced the number of working days in January 2009 by two compared with last year. So, the January numbers will probably exaggerate the weakness of foreign trade developments in China and the rest of Asia, while the February data will most likely come out relatively strong.

Key events of the week ahead

  • In China, focus will be on the foreign trade numbers, lending data and January inflation figures due out in the coming week.
  • In Japan, new machinery orders and current account numbers for December are due to be published on Monday.
  • In the rest of the Asian region, attention will mainly focus on Thursday's policy meeting at the Bank of Korea. Given the very weak indicators, we expect the BoK to cut rates by 50bp to 2.0%.

FX: New tax rules could send dollar and yen stronger

Recently, FX markets have again focused quite a lot on the outlook for changes in tax rules on profit repatriation by multinational companies. In the US, speculation has it that there is lobbying in the Senate for incorporating a version II of the 2004 Homeland Investment Act in the Obama administration's fiscal stimulus package. Meanwhile, the Bloomberg news agency has reported that a similar (and permanent) scheme could be under way in Japan. Both proposals concern tax reductions on profits repatriated by companies with activities abroad. The aim is to boost the investments of domestic companies at home and hence to make sure that they support the domestic economy. A similar proposal was adopted in the US in 2004 under the name of the Homeland Investment Act as part American Jobs Creation Act. The act allowed US companies to repatriate foreign profits for one year at a tax rate of just 5.25%, against the normal tax rate of 35%, provided that the money was used for activities supporting job creation. The act had a visible impact, and 2005 saw large capital inflows into the US - estimated at around USD200bn. While companies reacted to the incentive changes, the effects on the real economy and employment were more doubtful, though.

Meanwhile, the impact on FX markets was quite obvious. All else being equal, the strong capital inflows into the US should strengthen the dollar. And, in fact, analysts over the course of 2005 referred to the tax changes as an argument for dollar strengthening, and actual exchange rate developments seemed to support this view. As figure 1 below shows, the dollar had weakened gradually since 2002, but the greenback's depreciating trend was halted temporarily in 2005, and the effective dollar index rose almost 7% over the year. That said, it is doubtful whether capital repatriation was the reason for the dollar's strengthening in 2005, as the Federal Reserve had already begun hiking rates in 2004, while the ECB did not follow suit until in December 2005. This was, not least, because the US left the 2001 recession behind it far earlier than Europe, which helped to boost the dollar. Note also that a large part of repatriated assets were denominated in USD, which dampened the effect on the US currency.

Whether there is political backing for changing repatriation tax rules now is doubtful, though - not least, in the US. Note in this connection that any similar tax rule changes in Japan could further support the yen, although the proposed Japanese scheme is permanent, which would probably mean the immediate effects of the changes, if adopted, would be considerably more modest than those seen in the US in 2005. The short-term effects could even be negative for the JPY, as Japanese companies would probably consider putting off any repatriation beyond the current fiscal year ending on 31 March if the changes are adopted or seem likely to be adopted. All things considered, we expect the tax debate to remain an important theme on FX markets until the issue has been clarified in greater detail.

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