The impact of even dramatically slower growth in Europe would only trim US growth fractionally; Asia is far more important for the US outlook (see Global Economics: Asian Amplification, February 4, 2010). However, the European sovereign crisis does create a tail risk for US growth and markets: If the crisis spills over into broader risk-aversion and a drying up of liquidity - the functional equivalent of the US subprime crisis - the consequences could be more dire. At the least, these unknown risks make us more cautious about risky assets (see Sovereign Crisis Roadmap, February 11, 2010).
Challenge to sustainable growth. Strong growth abroad is one of four pillars for our view that the US economy is at the start of sustainable growth through 2011 (the other three: improving financial conditions, persistent impact from fiscal stimulus, and the elimination of excesses (see Outlook 2010: Higher Rates, Fed Exit and Sustainable Growth, January 4, 2010). Thus, a slowdown in Europe's economies would at least challenge that thesis.
Indeed, from a short-to-medium-term cyclical perspective, the crisis seems likely to slow European growth through three channels: 1) rising risk premiums on the region's sovereign debt will tighten financial conditions; 2) higher funding costs and constraints on market access will limit the supply of bank credit; and 3) fiscal tightening - both spending cuts and tax increases - will weigh on growth in peripheral economies. In turn, the willingness of core EU countries to backstop the periphery, perhaps with an emergency lending facility sponsored by Germany, seems likely to cause the contagion to spread to the core. As a result, we now expect 10-year Bund yields, which have begun to rise despite soft incoming European data, to rise to 4.5% this year. A weaker euro will be a partial offset by helping boost the region's export competitiveness; we expect the euro to decline to 1.24 EUR/USD.
Quantifying the fallout for the US. We estimate that a one-percentage-point slowdown in European growth might shave 0.2% from that in the US. Three channels matter: exports, earnings and financial linkages.
Exports: Big share, but slow growth. Exports of goods and services to the European Union account for 29% of the US total, but given our outlook for tepid EU growth, the contribution to US growth from European demand is small. Nonetheless, a dramatic slowdown in European demand would dent US export growth. In contrast, Asia ex Japan is growing eight times faster than the EU, and Canada and Latin America are growing four times faster. The share of US exports of goods and services to Asia (27%) is comparable to the EU, while Canada and Latin America account for 37%. We see upside risks to both those sources of export vigor.
Earnings/Income: An important, overlooked channel. US income from direct investment is much more closely coupled to Europe, because Europe accounts for 57% of the US$3.1 trillion in overseas facilities owned by US companies. So, a slowdown in European growth will affect results at US affiliates in the region, which contribute roughly one-sixth of US earnings. Slower growth in Europe would slice 200-300bp from the likely rise in US earnings this year. Fortunately, the growth differentials matter; while Asia accounts for only 20% of direct investment income, its rapid growth is contributing a like amount to US earnings growth.
Financial linkages to Europe: More diffuse and hard to calibrate, but could be noticeable. A rise in core European sovereign yields could intensify concerns about the sustainability of US fiscal policy among global investors and push up US Treasury yields. Uncertainty about the slowdown in Europe might weigh on US credit and equity prices. Slower growth in Europe would depress results at US global financial services firms and could make them more hesitant to lend. US financial exposure to Europe is relatively low: For example, US banks' claims on residents of the European periphery were a miniscule 0.3% of total assets as of 3Q09, and claims on all European residents amounted to only to 4.6% of total assets (see Betsy Graseck's Quick Comment: International Exposure a Low Risk for US Banks, February 10, 2010). As we learned in the financial crisis, however, such linkages could be the most important of all if idiosyncratic risk morphs into something systemic. Indeed, while the retreat in risky assets in the past few weeks is not yet a headwind for growth, it is hardly a plus (for credit implications, see Problematic Relatives - Downgrading € IG Credit, February 12, 2010).
Cross checking. To cross-check these results, we estimated a Vector Auto Regression among three variables: Growth in US GDP, US domestic demand, and overseas GDP. Shocking the system with an impulse response shows that a 1pp change in the growth of foreign GDP will move US GDP growth by 60% of that, which is consistent with our back-of-the-envelope calculation of a 0.2% impact from a similar change in Europe alone.
Contagion tail risk. Our base case is that peripheral Europe will muddle through with assistance from the core. Yet the crisis will surely slow European growth somewhat. Contagion spreading from the European banking system is the biggest tail risk. If the crisis spills over into broader risk-aversion, a drying up of liquidity, and deleveraging - the functional equivalent of the US subprime crisis - the consequences could be more dire. That scenario is far from investors' minds, and we think it is highly unlikely, given that EU officials have made it clear that conditional assistance for Greece is coming. But that's what makes it important to think about.
Bernanke More Specific on Exit Strategy
Fed Chairman Ben Bernanke's congressional testimony on Wednesday, February 10 reinforced the notion that progress towards an eventual Fed exit is underway. Yet Bernanke did not provide much insight with regard to the timing of the exit, and it's clear that the Fed is still engaged in internal debate on the specific strategies that will be employed.
We continue to believe that the exit process will unfold fairly quickly during 2H10, spurred by market-based indications of rising inflation expectations as the economic recovery takes hold. The time lag between actions aimed at draining a significant volume of excess reserves and the hiking of policy rates is likely to be relatively brief, putting the IOR (Interest on Reserves) program to the test (note: the current volume of excess reserves is US$1.063 trillion versus a ‘normal' level of US$1.5 billion).
We have three key takeaways:
Discount rate: The Fed is getting closer to hiking the discount rate. This would be a technical adjustment aimed at restoring the normal 100bp spread between the discount rate and fed funds rate that was originally established as part of some broader adjustments to the discount window program in 2004. The fact that Bernanke is now highlighting such a change means it is likely to occur sooner rather than later, but it should not be viewed as a policy signal.
Sequencing: The Fed will begin testing the term deposit program sometime in the spring, and Bernanke noted that "hundreds of billions of dollars" could be drained from the banking system "quite quickly" using term deposits and reverse repos. While the sequencing remains somewhat unclear, the bottom line is that it appears to be data-dependent.
Interest on reserves (IOR): Bernanke indicated that the stance of policy might be best communicated using the IOR rate rather than the fed funds target - at least during the initial stage of the exit process. The announcement of changes in the IOR rate could be accompanied by the specification of quantity targets for excess reserves.
In our view, the potential reliance on the IOR rate during the early stages of the exit process reflects the fact the Fed cannot be certain that IOR will work as intended. The IOR program was introduced in autumn 2008 in order to help prevent the effective fed funds rate from falling too far below the official target rate as the Fed balance sheet ballooned. However, for a variety of reasons, the funds rate traded well below target for an extended period of time. The majority of Fed officials seem to believe that the program will work more effectively going forward, but they have publicly admitted that they cannot be certain. As a result, until markets normalize, the Fed will look to other money-market rates - e.g., UST repo - to gauge money-market conditions.
When the system returns to normal, the Fed, like other central banks, will have a corridor system for rates. IOR will be the floor, the discount rate will be the ceiling, and the funds rate will lie between them.
‘Cleaner' Jobless Claims Data Support Optimism on Labor Market
The jobless claims report released on Thursday, February 11 showed that filings plunged 43,000 in the latest week to 440,000, the lowest reading since the week ended January 2. A Labor Department official indicated that the plunge reflected "the end of an administrative backlog" rather than any significant change in economic conditions. Moreover, the state-by-state breakdown, which is released with a one-week lag, showed that filings remained quite elevated in the state of California during the week of January 30. As we've noted over the past few weeks, almost all of the recent volatility in claims has been tied to swings in California. It appears likely that California claims plummeted in the latest week as the state's backlog was finally resolved (last week, a local press report indicated that state legislators were pressuring government employees to speed the processing of claims). Moreover, even assuming a return to the November/December trend in California, it looks like claims posted a meaningful decline across the rest of the US in early February. So, while we still have some unanswered questions regarding the recent gyrations in claims, it appears that underlying conditions may have improved a bit over the course of recent months.
In all, the latest claims data reinforce our optimism regarding the progress towards recovery in labor market conditions. As we've been noting for some time, the recent surge in productivity growth appears unsustainable, and if the turnaround in economic output is going to be sustained, companies will need to begin to add some labor. The claims data, layoff survey info, rising temporary help jobs, and consumer sentiment gauges are all supportive of this gradual progress toward recovery in the labor market. (As we have noted in the past, the continuing claims and emergency claims data are not sending a clear signal in one direction or the other and should be ignored.) Also, despite our survey results to the contrary, we still think that reduced uncertainty regarding the potential for a significant new cost burden being imposed on businesses as part of the healthcare reform initiative could help to unleash some hiring.
Our major concern related to employment over the near term is the impact of severe winter storms. The latest storm hit the East Coast during the survey period for the February labor market report. On a preliminary basis, we are assuming about a -100,000 impact on February payrolls tied to unusually severe weather (this is the estimated weather impact, not a payroll forecast). Our estimate is based on the experience with the blizzards of 1996 and 2003. We will receive more information in coming days that might be helpful in refining these estimates, and we will release a more comprehensive February employment forecast next week.
The Treasury market saw significant long-end-led losses over the past week that sent the yield curve to new record highs as global market attention was mostly on developments in Europe through the week until China came with another surprise required reserve ratio hike on Friday that allowed Treasuries to make back ground after a run of four days of losses through Thursday when attention was on Greece. Domestically, a lot of Treasury market focus was on the refunding auctions, all three of which were on the soft side, which we haven't seen in a run of auctions in a while. Big adjustments in mortgage market valuations and positioning also were substantial rates markets movers after Fannie Mae and Freddie Mac boosted efforts to buy delinquent mortgages out of their guaranteed MBS pools, with a significant late week underperformance by higher-coupon MBS but a strong relative showing by lower coupons. Domestic economic data were generally positive but had limited market impact. We boosted our forecast for the 4Q GDP revision to +5.9% from +5.8% but lowered our 1Q tracking estimate to +2.5% from +3.0% as exports and imports both continued surging in December, but the latter more so. Upside in retail inventories pointed to stronger growth in 4Q at the expense of 1Q, while final domestic demand is showing a bit of acceleration as retail sales showed a solid gain in January and a big gain in December capital goods imports added to recent data pointing to a decent pick-up in business investment.
Domestic developments were certainly of limited market interest, however, as attention was instead largely on Europe through most of the week and then China Friday. The decision by the EU to announce support not just for Greece but potentially for all fiscally troubled EMU members (in a vague initial statement that is expected to be fleshed out into more concrete proposals as soon as the upcoming week) supported a big tightening in spreads of Greek government bonds versus benchmark German bunds. After initially moving to new highs Monday, the Greece/Germany 2-year spread hugely reversed course and tightened about 125bp on the week to near 415bp. Moves not quite as dramatic but still very large (particularly relative to much lower rate levels) were seen in 2-year government spreads over Germany for Spain, Portugal, Ireland and Italy, with moves on the week near 50bp, 95bp, 60bp and 30bp, respectively. Against this lowered perceived risk in these countries versus Germany and France, however, was a growing realization later in the week that having Germany and France perhaps effectively backstop the financing of Greece and other fiscally strained EMU members clearly greatly reduces risk of an imminent crisis but really just diffuses the problems in the periphery more broadly through the Eurozone. If we've now discovered that Germany is the ultimate backstop for Greek government debt, then Germany's fiscal position and sovereign risk is potentially worse than previously perceived. Wednesday and Thursday this was starting to be reflected in a small way in spread narrowing coming not just from rallies in the recently more troubled EMU countries, but also by a bit of softness in bunds. Friday's EMU GDP data brought more into focus, however, some softening in the underlying economic picture in Europe that was developing even before the sharp fiscal tightening that the EU is calling for in coming years from Greece and other countries. Still substantial, if now less acute and more diffuse, fiscal concerns in a weak economic backdrop weighed heavily on the euro Thursday and Friday after an initial bounce on optimism about EU fiscal support. With focus on Greece, holidays coming and a benign CPI print, China had become a much lesser market concern until Friday when a second surprise required reserve ratio hike in a month was implemented. The heightened global growth concerns from fears that China could move behind mopping up excess liquidity into a more aggressive tightening campaign added to the more negative view on Europe to support decent Treasury market gains Friday. Fiscal concerns remain high globally, however, and real rates continue to see upward pressure at the long end of the TIPS market, while the ECB now could on hold longer than previously expected and the Fed shows few signs of imminent action even after Fed Chairman Bernanke at least made clear that the Fed has an exit strategy sequencing excess reserve draining and rate hikes when they do eventually decide it's time to move. Slower global growth from Europe's problems and potential fallout from China tightening and ‘lower for longer' short rates in the developed world combined with mounting fiscal concerns across many major developed economies were a recipe for a steeper yield curve, and that's certainly what we've continued to get.
At the early Friday afternoon time of writing, benchmark Treasury yields were 7-15bp higher on the week and the curve significantly steeper and at all-time highs. With the 2-year yield up 7bp 0.82% and 30-year 15bp to 4.64%, 2s-30s was sitting at a new high of 382bp, moving above the prior peak of 380bp hit January 11 ahead of the first of China's now two surprise reserve ratio hikes. With the 10-year up 13bp at 3.67%, 2s-10s was 5bp steeper at 285bp, not quite through the all-time high of 289bp hit January 11. Given the size of the losses in the nominal market, relative TIPS performance was quite weak, with almost all of the losses at the longer end of the curve coming in a real rate adjustment. The benchmark 10-year inflation breakeven was only up about 1bp on the week at 2.25% Friday as the 10-year TIPS sold off almost as hard as the 10-year nominal. While substantial late week downside in commodity prices - on both the weaker euro/stronger dollar and also China's tightening move - added to pressure on TIPS, at the longer end of the TIPS market there has been persistent pressure over the past week-and-a-half or so regardless of day-to-day moves in commodity prices. We expect fiscal strains domestically to contribute to a substantial real rate adjustment at the longer end continuing throughout this year. Mortgages were thrown into some disarray late in the week after Freddie and Fannie's moves to step up repurchases of delinquent mortgages shook up estimates of MBS prepayments and duration. For the lower coupons, this provided a lot of relative support, and current coupon mortgage yields rose a lot less on the week than Treasuries, extending a period of comparative yield stability. Current coupon MBS yields have been in a narrow range of 4.3-4.4% for most of the past month and were trading not far from the middle of that range Friday afternoon. This has kept average 30-year conventional mortgages rates very close to 5% the past month.
A quiet economic calendar the past week (fortunately so given the major weather disruptions in Washington) was generally positive, though stronger-than-expected imports relative to also surging exports pointed to slightly lower domestic output over 4Q and 1Q. Imports and exports both continue to strongly recovery from the collapse seen from mid-2008 into the spring of 2009, clearly a very positive indicator for the global economy. Domestically, however, the rebound in imports has been outpacing the recovery in exports, providing a bit more of a short-term drag on GDP growth than we previously expected. Incorporating a wider-than-expected December trade gap, we see net exports being 0.2pp more negative in 4Q and 1Q. Meanwhile, the already huge add to 4Q GDP growth looks to have actually been even bigger after an upside surprise in retail ex auto inventories in December relative to BEA's assumption following an upside surprise to non-durable manufacturing inventories reported the prior week. We now see inventories adding 3.9pp to 4Q GDP growth instead of the initially reported +3.4pp, but with an offset to 1Q. We now expect inventories to be neutral for 1Q GDP instead of adding a few more tenths. With demand continuing to grow modestly, over the medium term inventories will still need to see further upside to stabilize inventory/sales ratios that have moved back down to lean levels as of the end of 2009 after a major inventory correction over the course of the year. A solid retail sales report continued to support expectations for a moderately positive trend in final domestic demand. We see real consumption gaining 2.5% in 1Q after rising 2.8% in 3Q and 2.0% in 4Q, with some volatility in 2H09 caused by cash for clunkers. Netting this all together, we now expect 4Q GDP growth to be revised up to +5.9% from +5.7%, slightly better than the +5.8% revision we expected coming into the week, and we now see 1Q GDP growth tracking at +2.5% with final sales (GDP ex inventories) also at +2.5% but final domestic demand (GDP ex inventories and net exports) accelerating to +3.1%. These adjustments around the margin haven't prompted any shifts in our outlook for a moderate but sustainable recovery in 2010, and we still see real GDP growing +3.2% in 2010 (on a 4Q/4Q basis).
Retail sales rose 0.5% overall in January and 0.6% excluding a flat result for autos, boosted by solid gains across a number of discretionary categories, including general merchandise (+1.5%), electronics and appliances (+1.2%), and sports, books and music (+1.0%). Non-store retailers (+1.6%), which includes dedicated internet retailers, also extended a strong recent trend, and the heavily weighted grocery store category (+0.8%) reversed an unusually big drop seen in December, possibly as a result of weather disruptions. On the softer side, the most housing-centered components - building materials (-1.2%) and furniture (-1.4%) - remained weak. Gas stations (+0.4%) also saw a smaller rise than we expected, based on the upside in gas prices, and drug stores were flat. Without the drag from building materials, the key retail control grouping (sales ex autos, gas stations and building materials) was a strong +0.8% in January. Since bottoming in July, retail control has now risen at a solid 5.7% annual rate. Along with a bit less than 4% annualized growth in services spending, this has left overall nominal consumption trending at close to +5% and real spending near +2.5%, which is right where we see 1Q tracking after some mild volatility around this level in 3Q (+2.8%) and 4Q (+2.0%) caused by cash for clunkers.
The trade deficit widened to US$40.2 billion in December from US$36.4 billion in November, as a 3.3% surge in exports trailed a 4.8% spike in imports. Imports fell harder during the near collapse in world trade in the nine months through April, but have since rebounded more sharply - exports fell 26% in the nine months through April and are up 17% since, while imports dropped 35% and have rebounded 22%. As a result, there has been a bit of a drag on US growth since mid-2009 from trade after it helped to cushion somewhat the plunge in output in late 2008 and 1H09. In the three quarters ending in 2Q09, net exports added 1.6pp annualized to GDP. This turned to a 0.8pp drag in 3Q, what we expect will be a downwardly revised 0.3pp add in 4Q, and a projected 0.7pp negative in 1Q for an annualized -0.4pp contribution from 3Q09 to 1Q10. With developing world growth accelerating sharply this year and expected to well outpace US domestic demand growth, we continue to expect that stronger net exports will return to being a meaningful net positive for US growth over the rest of 2010.
The economic calendar is a lot busier in the upcoming holiday-shortened week. While we wait for Congress to schedule Fed Chairman Bernanke's semi-annual monetary policy testimony, the minutes from the January FOMC meeting will be released on Wednesday. While the dissent against the prediction of "exceptionally low levels of the federal funds rate for an extended period" by Kansas City Fed President Hoenig moved the markets significantly when the last FOMC statement was released, the minutes will probably show (as in December) that the internal argument was more two-sided, with dovish members supporting an extension of Fed mortgage purchases. The next wave of supply will be announced Thursday - 2s, 5s, 7s and the return of the 30-year TIPS in place of the current 20-year benchmark. On the data calendar, it will be time to start setting expectations for the upcoming employment and ISM reports after claims on Thursday, Empire State Tuesday and Philly Fed Thursday. Initial claims in the latest report, which covered the survey period for the February employment report, showed a sharp drop and finally appear to have normalized after a month of upside centered in unusually high readings in California. California apparently has finally cleared a big backlog of unprocessed claims, while it seems that the rest of the country might have seen some small worsening from early January to early February, though nothing too notable compared to the big improving trend still in place since late last summer. We want to see the state-by-state data for the February survey week that will be released in the upcoming report before setting our initial forecast for February payrolls, but it appears that the underlying trend at this point is probably slightly positive. Note, however, that the past calendar week was the reference week for the February employment survey, and clearly there were some major disruptions from the blizzards. Our initial best guess is that the bad weather might lower February job growth by about 100,000. Adding to potential distortions on the other side, however, census hiring should be starting to ramp up after a small amount of hiring in January. Other key data releases due out in the coming week include housing starts and industrial production Wednesday, PPI and leading indicators Thursday and CPI Friday:
* We expect January housing starts to fall to a 540,000 unit annual rate. Construction jobs in the residential sector fell 15,000 in January - the worst performance since September. And home sales have pulled back in recent months following a tax break-driven surge in the fall. So, we look for about a 3% dip in overall starts in January. In particular, we look for a pullback in the volatile multi-family category, which has been surprisingly strong lately.
* We look for a 1.1% gain in January IP. The employment report pointed to a sharp rise in factory output during the month of January. In fact, headline IP is expected to post its best gain since August, with a solid rise expected in the key manufacturing category accompanied by another weather-related jump in the utility sector. By industry, the strongest performers are expected to include electrical equipment, machinery, motor vehicles, petroleum and chemicals. Finally, the utilization rate should continue to recover from the extremely depressed readings seen in 2009 and is expected to hit a new 14-month high in January.
* We expect the producer price index to surge 0.8% overall in January but only 0.1% ex food and energy. Rising quotes for wholesale gasoline and natural gas are expected to help push up the headline PPI in January. Also, the food category is likely to show some further upside following a sharp 1.4% jump in December. Assuming some stabilization in motor vehicle prices, the core should register a reading that is right in line with the underlying trend.
* The index of leading economic indicators should rise 0.3% in January, its tenth straight gain to extend the strongest run since 1983. The main positive contributors this month should be the yield curve, supplier deliveries and the manufacturing workweek. The real money supply will be a significant offsetting negative, in our view.
* We look for the consumer price index to rise 0.3% overall in January and 0.1% ex food and energy. A rise in gasoline prices and a weather-related jump in quotes for fruits and vegetables are expected to lead to some modest elevation in the headline CPI. Meanwhile, the core is likely to remain well contained, with continued softness in the key shelter category offsetting slight price gains elsewhere. On a year-on-year basis, the core is expected to slip a tick to 1.7% - and base effects are likely to lead to some further moderation in this measure over the next few months.
Summary and Conclusions
In this report, we focus on the fiscal situation in Portugal and compare it with that of other EMU peripherals. We reach six main conclusions:
• Current market concerns have more to do with short-term liquidity risk than long-term solvency risk. Volatility is likely to remain high, though it might not truly reflect the fiscal fundamentals.
• Core and peripheral EMU countries are deeply intertwined. Contagion risk, should it materialise more visibly, might have euro area-wide implications.
• Greece is in a unique situation in Europe, we think. Although the other EMU peripherals are superficially similar to Greece in some respects, none of them scores poorly on so many fronts.
• Portugal's fiscal fundamentals are not too different from the ‘typical' euro area country, though it has high private sector debt and a wide current account deficit relative to the size of its economy.
• There is considerable scope for Portugal to boost GDP growth through structural reforms. In particular, product market liberalisation and allowing for market competition are key, in our view.
• Although the 2010 budget has not yet been approved, we think that the solid social cohesion in Portugal bodes well for these reforms taking place.
Liquidity Risk versus Solvency Risk
What's in the Price?
Sovereign risk analysis is back in vogue in Europe. Markets are increasingly concerned about the fiscal positions of several European countries, mainly at the EMU periphery. For example, the cost of insuring against default in the credit default swaps (CDS) market has risen (and bond spreads have widened).
In Portugal too - and even more so in Greece - the 5-year CDS spread, which measures the cost of insuring against a government violating the conditions of a debt contract, has increased notably. At over 200bp, the spread indicates that a buyer of such protection would need to pay two cents every year for $1 of protection against the Portuguese government defaulting.
This implies that the markets are pricing in slightly less than a one in five chance of the government defaulting over the next five years, under the assumption that 40% of the principal is recovered in the event of a default. We disagree with this, and think that current market concerns have more to do with short-term liquidity risk than long-term solvency risk.
To assess the short-term risks around the EMU peripherals, our interest rate strategists have put together an estimate of the funding-related cash flows for these countries (see European Interest Rate Strategist - Sovereign Risk in Context, February 5, 2010). Of course, the coupons and redemption amounts are known. But the future supply numbers are unknown. Our strategists have projected them according to the historical supply patterns and the borrowing requirements announced by the individual countries. The starting point of this exercise is the government cash balance at the central bank. Then, the cumulative cash balance is projected according to the funding-related inflows and outflows.
The schedule of coupons and redemptions shows the pressure points for the individual countries. For Portugal, May is the big payout month. Spain paid almost €27 billion of redemptions in January, but faces another €30 billion in July. For Greece, the pressure points are April and May, when the government will need to pay €20 billion of coupons and redemptions. From this perspective, event risk and volatility remain high, though they are not necessarily a true reflection of the long-term sustainability of the Portuguese public finances, for example, as we will see in the next section.
Gauging the Contagion Risk
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