At 4.6%Q (seasonally adjusted and annualised), 1Q10 GDP came in ahead of our own and market expectations of 4.0%Q and 4.3%Q, respectively, driven in the main by a strong manufacturing, mining and financial performance. For the year as a whole, we continue to look for an above-consensus 3.3% print. Here's why:
Stronger-than-Expected Rebound in Industrial Production
Accounting for most of the surprise in today's reading relative to our forecast was an 8.4%Q rise in value-add by the manufacturing sector. As suggested by the monthly data published earlier by Statistics South Africa, this rebound was led across a number of industries, but particularly in the basic iron & steel and petroleum & chemical product divisions. However, the monthly data had pointed to no more than 6.1%Q growth in manufacturing production - much lower than the 8.4%Q clip that was published in the GDP print: Although the monthly data do not always correspond fully with the final value-add estimate - thanks largely to statistical rounding effects, seasonal quirks, etc. - we believe that the difference in this particular reading is simply too large to be assumed away as a rounding error. Accordingly, we suspect that there may be some downside risk to the upcoming 2Q10 reading.
Broad-Based Recovery Now Evident
Playing less of a role in our forecast error, but encouraging nevertheless, were the stronger-than-expected readings across several other sectors, including electricity, gas & water, wholesale & retail and finance & real estate. Value-added by the electricity sub-sector overshot our forecast as the production and consumption of power rebounded strongly after a rather weak 0.9%Q print in 4Q09; wholesale & retail activity is now back in expansionary territory after seven consecutive quarters of contraction; and the finance & real estate sectors appear to be gaining sustainable momentum as policy rates remain low, house prices recover and both business and consumer confidence levels improve. There are some headwinds, however: These include particularly lethargic rates of domestic credit extension, still-fragile global capital markets and uncertainties over the end game in European sovereign developments.
Agriculture and Construction Lagging
At 3%Q, the rebound in agricultural production was not as brisk as we had hoped for, suggesting that there could be some upside surprises in the coming quarters. Press reports of a bumper maize harvest this year, for example, are yet to show up in the GDP data. Construction activity also surprised us to the downside - presumably driven by weak corporate appetite for capital stock renewal. We had hoped for fairly strong construction activity ahead of the soccer World Cup next month. Much of the kicker is clearly behind us.
Policy Rate Implications
The GDP fan chart presented to the May MPC suggests that the central bank expects growth to settle at around 3-4.5%Q between now and 2012, and for the 1Q10 outcome to have printed at 3.7%Q. Ceteris paribus, this implies upside risk to the SARB's 2010 estimate of 2.7%Y. We believe that a more favourable growth outcome and some rebalancing from a weaker currency could call for policy normalisation as early as 1Q11. We therefore maintain our view that the first policy rate hike will be delivered in 1Q11 - a quarter or so earlier than suggested by current FRA pricing.
1. Impact on Japan of Europe's Sovereign Debt Problems
Europe Has Avoided Intensive Care, but Faces a Long Period of Recuperation Which Could Have Repercussions for Japan
The arrangement by leading central banks on May 10 of a dollar fund swap agreement has contained the liquidity problem. This has averted disruption to trade from financing constraints, as occurred after the Lehman shock of 2008 when trade finance dried up. Japan was one of the countries most directly affected by the breakdown of global trade financing at that time, but swift action by the authorities now appears to have avoided the danger of a repeat. However, we cannot rule out the possibility that Japan will suffer indirect damage as Europe's economy slows further, with fiscal austerity across the region and lending attitudes becoming tighter as concern over the capital base of banks escalates.
Yet We Made Technical Upward Revisions to Our Outlook
Notwithstanding these concerns, the outlook for the economy in the very near term is actually in upward revision mode. For example, our US economics team has increased its GDP forecast from +3.2% to +3.4%. According to the team, US GDP is affected by only 0.2% even if growth in Europe slips by 1pp.
Japan's economy is already within range of real growth for calendar 2010 of 3.4%, on par with the US (2.7% for F3/11), based on the Jan-Mar GDP data from May 20. Among the G3, Japan's growth rate trails only the US and is founded on brisk external demand, chiefly exports to Asia. In this respect, the effect of stagnation in Europe on external demand is a risk.
For Jan-Mar alone, Japan achieved the highest rate of growth among the G3, and personal consumption was a key driver alongside external demand. However, most of this consumption demand was fed by durable goods benefiting from stimulus packages, and with eco-vehicle subsidies expiring at end-September and the eco-point program expiring at end-December, we are expecting retracement in consumer durables spending from the start of 2011.
In summary, while there may be technical GDP upside in the near term from a rise in the base effect, economic activity has now passed the sweet spot, and we may well see renewed stagnation as policy effects erode in future.
Impact on Trade: Europe's Share of Japan's Exports Is Not High, but...
Next let's consider the implication for trade. According to the MoF data for 2009, Europe's share of Japan's exports was 13%, compared to nearly 50% for Asia and below the 17% for the US. Growth momentum for export volumes to Europe was sluggish for some time anyway, and we believe that some further slowing should not cut far into the overall export momentum, which is backed by booming trade with Asia.
How should we view things from the perspective of Europe, the export destination? Total imports for the region excluding intra-regional trade (2008 data, 27 EU nations) were $2.2 trillion, or roughly 13% of global trade. These imports came from 1) China (source of 14% of Europe's imports), 2) the US (13%), 3) Japan (5%), and 4) East Asia (excluding Japan and China; 11%), but Europe's links with Eastern Europe (not part of the EU category above), the Middle East and Latin America are strong (about 60%). Exports from Japan routed via these regions, which are effectively exports to Europe, make up an estimated 20% or more of Japan's total exports. In considering the impact of further deceleration in the EU economy, we need to look at the indirect impact of a slowdown in exports into Europe from countries other than Japan. In this case, a 1% slowdown in EU growth could take 0.2% off Japan's GDP, which is similar to the impact of change in US growth.
Impact of Yen Appreciation: Change in Nominal Effective Rates Has Not Been Very Large So Far
Elga Bartsch, our European economist, is forecasting GDP growth for the EMU countries of +0.9% in the base case and -0.5% in the bear case for 2010, and +1.1% (base) and -1.5% (bear) for 2011. If her bear scenario were to play out, Japan's GDP would be lower than in the base case by approximately 0.3pp in 2010 and 0.5pp in 2011.
If we add in the factor of yen appreciation to the slowdown in the economies of trading partners above, the downside for Japan's economy becomes larger. The yen has been relatively stable against the dollar, but against the euro it has gained to JPY111-112, considerably beyond the assumed rate of JPY125-128 in the business plans of export firms. The effective yen rate has not strengthened dramatically, partly because the nominal share of exports to Europe is quite small. But an increase in the dollar/yen rate of 10% would have an impact on Japan's GDP of -0.3pp in the first year, and a larger -0.5pp in the second year. Likewise, an increase in the euro/yen rate of 10% would have a negligible impact on Japan's GDP in the first year, but -0.1pp in the second year. This means that the risks to growth from exchange rate movements could be greater in 2011 than 2010. There is already the danger that Japan's economy could level off in 1H11 as policy-induced demand fades, hurting consumption in particular as outlined, and the recent gains for the yen versus the euro are a new risk factor.
Positives for the Global Economy: Stronger Dollar, Crude Oil Price, Long-Term Interest Rates
While rapid yen appreciation is a short-term negative for the Japanese economy, euro depreciation may work to ease deflationary pressures from fiscal restraints for the European economy. The EU27's trade volume is not insignificant, accounting for about 13% of global trade even excluding intra-regional trade. As the European economy is export-oriented, a cheaper euro could boost the regional economy.
Also, crude oil prices have abruptly corrected as the sovereign debt problems spread, pushing WTI now to below $70/barrel. During the previous economic slowdown, the global economy decelerated as the crude oil price shot up above $100. This time, however, as crude oil price started correcting even well before it reached $100 with the economic recovery still in process, we believe that recession risk from a sharp rise in resource prices would be limited.
Further, major central banks have pushed back their exit strategies as the sovereign issue spreads. Our US economic team now expects the fed funds rate target to be raised in Jan-Mar 2011, some six months later than Sep 2010 as previously predicted. US long-term interest rates have fallen to the lower 3% range as expectations for a rate hike have receded, and funds have shifted from risky assets to non-risky assets. A decline in long-term interest rates tends to prompt a fall in mortgage rates, lifting household discretionary income by boosting home loan refinancing. As we can expect such a built-in-stabilizer effect this time also, we see no need to factor for a risk of a significant economic slowdown in our forecast now, though we think Japan's economy will see a temporary lull in 2011.
2. Impact of Sovereign Debt Problems on Japan's Risk Assets
Sell into Rallies - If There Are Any
Swift conclusion of a dollar swap agreement among leading central banks on May 10 staved off dysfunction in the European short-term money markets, which serve as a hub for dollar fund settlement. For now, the likelihood of a panic comparing with the Lehman shock has been averted. However, our European economics team believes that the sovereign problems will ultimately conclude with debt reorganization (namely default) in peripheral nations, and views this EU/IMF and ECB funding assistance as a means of winning time.
Immediately after the bailout, risk asset markets saw a global short-covering rally, responding favorably to swift measures to tackle liquidity risk, but as is well recognized, solvency issues are tough to address even if the authorities respond to liquidity problems, with resolution of the former, requiring commitment to fiscal austerity over a long period. If sovereign risk escalates further, there is potential for impact on a broad range of risk assets. Indeed, the post-bailout optimism has now fizzled out, with risk assets now again correcting globally on concerns.
In this context, our global cross-asset strategist, Gregory Peters, recommends selling into any strength for risk assets in the near term. Put another way, there may be opportunities to profit from moral hazard-driven rallies in this period, and our Japan equity strategist, Alexander Kinmont, is actually somewhat more optimistic about Japanese equities than previously and has reduced the weight of cash in his model portfolio, and his existing domestic-value focus. Likewise, our China economist, Qing Wang, argues that the ongoing events provide the opportunity for a ‘Goldilocks' scenario for the Chinese economy. Furthermore, our European equity strategist, Teun Draaisma, has moved from an underweight to an overweight asset allocation for the European region.
Similarly, from a standpoint of global asset allocation, our global strategists, Jason Todd and Gerald Minack, are recommending selling Japanese export stocks and buying European exporters. Given the swings in exchange rates (euro losing ground, yen gaining) as the sovereign debt issues develop, we are comfortable with reducing exposure to Japanese exporters.
Downside Scenario: Widespread Impact on Multiple Asset Classes
More than the impact of trade contraction on the real economy, the point to be worried about is downward pressure on the economy from credit problems, such as a breakdown in the function of capital markets. Industrial production in Japan saw the largest plunge on record as trade financing shriveled after the Lehman shock, with risk assets in Japan suffering severer repercussions than in other markets.
Now that panic in financial markets has been contained by liquidity provisions, the latter risk need not be overemphasized. But our team's view is that debt reorganization (default) for peripheral European nations will be unavoidable. As the authorities have bought time until that point is reached, if credit events occur at a stage when debt reorganization has already been priced in, we believe that it should be possible to avoid the discontinuous changes in the market that followed the Lehman shock. Even so, if it turns out that risk has been more broadly dispersed than is apparent, for example via the repackaging of government bonds of the peripheral countries into securitized products, we could see debt restructuring having a compounded effect in multiple asset classes, affecting unexpected areas in much the same way that the Lehman shock battered money markets. We need to keep this risk in mind.
Upside Scenario: Debt Reorganization Marks the End of Negative News
The upside scenario is that debt reorganization for peripheral nations in the Europe region comes at a point when the implications have been fully priced in, and risk assets then rally on the end of bad news. For debt reorganization to take place smoothly without triggering similar upheavals of the Lehman shock, creditors would need to have made preparations such as ensuring that sufficient reserves were in place for the relevant bonds. This would necessarily take a fair amount of time, and so we think that a smooth and early debt reorganization process is after all a low probability.
Tracking the credit conditions in the borrowing country by lenders such as the IMF, as below, would be a useful way of keeping tabs on the possibility of debt reorganization. The markets are likely to swing one way or the other in response to the fulfillment of conditionalities and potential for debt restructuring.
Overview of the IMF/EU's Package
On May 9, the IMF's board approved a three-year Stand-By Arrangement (€30 billion) for the country at issue. This, along with the funds (€80 billion) earlier approved by eurozone member states, made a total of €110 billion officially available to the nation in need of assistance. The first tranche of €20 billion (€5.5 billion from the IMF, €14.5 billion from the EU) has already been disbursed, easing short-term liquidity problems for the time being.
But whether loan disbursements will be smoothly made during this three-year period depends on meeting conditionalities every quarter. Specifically, they include numerical fiscal targets (‘performance criteria' such as upper limit for the general government fiscal deficit) and structural measures laid out in detail each quarter. If governments fail to meet the targets, the probability rises that the program will slide off-track and funding from the IMF and eurozone countries be suspended.
Our European economists, Daniele Antonucci and Elga Bartsch, point out that a restructuring can still happen within the three-year loan period. Their first reason is that the country might not deliver on this program, and so the money flow might stop. Second, though a low probability in the near term, the country might refuse to tighten sufficiently at some point because policymakers think it excessive. The program would go off-track in this case too. Third, Daniele and Elga point out that there might still be some kind of voluntary restructuring further down the line.
The question of whether conditionality can be observed looks like a technical one at first, but its roots go deeper. Ordinarily, when a country undertakes fiscal adjustments, the best prescription is to employ accommodative monetary and forex policy and avoid abrupt contraction in aggregate demand. But countries with a common currency cannot pursue independent monetary and exchange rate policies without leaving the currency zone, so their economies are vulnerable to severe deflationary pressure if extensive fiscal adjustment is undertaken. In other words, they would likely face negative GDP growth, falling wages and prices, and rising unemployment. In the case of the country at issue currently, the IMF is forecasting negative growth for three successive years to 2011, but our European team is expecting wider margins of the negative growth than the IMF. Even the IMF, with more optimistic forecasts, is assuming the unemployment rate will soar to 14.8% in 2012. As the cases of several countries including Japan show, politically there is only a narrow path for implementing structural reforms at a time of economic contraction.
This gives critical importance to upcoming quarterly reviews of progress towards meeting loan conditions conducted by the IMF. If the program review goes smoothly, the likelihood of debt restructuring would diminish, while if conditions are not being met, the market would factor for a higher probability of debt restructuring. We would naturally expect risk assets in Japan to reflect these trends.
Rebound in Exchange Rates
Another risk scenario is a snapback in yen exchange rates. If sovereign debt problems were to recur in Europe on a larger scale, we think the yen could well provide a haven for buyers, as the currency of a country with current account surplus. This is no more than a risk scenario, but when the New York stock market sold off sharply on May 7, the yen was temporarily bid up to a level of JPY88 to the dollar.
Furthermore, with the ECB following the Fed among the G3 central banks in transitioning to quantitative easing, the soundness of the BoJ's balance sheet is likely to take on greater prominence. In our view, the size and capital ratio of a central bank's balance sheet have little to do with the institution's credibility, and the ECB's credibility should not necessarily be hurt by its moves to buy government bonds. Instead, it is the cumulative policy track record which earns credibility for a central bank. However, the consensus market view is that the ECB's credibility has been dented, and our European economics team does have concerns on that score. In these circumstances, if the BoJ is unable to move flexibly to quash deflation, we must assume that conditions would become conducive to buying of the yen generally - not just at the expense of the euro - as the markets focus only on the superficial health of the BoJ's balance sheet.
The above is presented as a risk scenario, and is not the house view of our currency strategy team. That said, our US economics team has revised its US interest rate outlook to no longer envision a rate hike by the end of the year, and since we do not expect the gap between US and Japan interest rates to widen by much within this year, we think that this risk is becoming all the more pronounced.
3. Possibility of Credit Concerns Spreading to Japanese Debt
Japan Is Not at High Risk of Contagion
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