That was then. Two months later, markets have swung towards fears of a double-dip slowdown, and risk-aversion is palpable. In contrast, we still see a moderate, sustainable recovery as the most likely outcome. But we also think that new uncertainty around economic policies at home and abroad is creating downside risks to US and global growth through two channels:
• First, consumers and businesses may hesitate to commit to spending and hiring decisions until policy uncertainty diminishes.
• Second, renewed uncertainty and consequent renewed weakness in asset prices has reversed some of the easing in financial conditions that has revived economic activity.
Together, those effects could turn market fears into a self-fulfilling prophecy; the interplay among them could magnify the headwinds from each considered individually. In that context, we agree that declining Treasury yields are scant comfort; they are barometers of risk-aversion rather than props for growth. Conversely, however, more clarity about some of these policy issues could reduce both of these headwinds. Two kinds of clarity are needed: Specific remedies where appropriate and, where specifics aren't immediately available, stating the goals of policy and indicating how officials will respond to changing circumstances - akin to what central banks refer to as their ‘reaction function'.
Domestic policy limbo. That such hesitation by households and businesses and weakness in asset prices can be traced to uncertainty around economic policies is hard to prove. But there is no mistaking the growing list of domestic and global policy issues that has left investors in limbo. At home, there is uncertainty about coming tax hikes, more stringent financial regulations, who will shoulder the costs of healthcare, policies to mitigate mortgage foreclosures, latent protectionism and policy attitudes towards business.
Uncertainty around taxes could promote higher consumer saving at the expense of spending; uncertainty about needed regulatory reform likely is stymieing willingness to lend; and uncertainty about the burden of healthcare reform may be a hurdle to hiring. Moreover, a slow start to new mortgage foreclosure remedies has left housing in limbo; latent protectionism could fan fears of a destructive trade war; and uncertainty about government attitudes toward business may give an incentive to delay actions until the outcome of the November Congressional elections and their implications for any policy changes are clearer.
Global erosion of risk appetite worrisome. Global uncertainties center on the impact on growth of Europe's sovereign credit risks; on the ability and/or willingness of policymakers to address weakness in the European banking system; and on the impact of fiscal restraint in Europe. To be clear: We continue to expect tepid growth in Europe; additional weakness there would have only a small direct impact on global and US growth. Fiscal restraint will be phased in over time, so the near-term growth impact should be far smaller than feared. What worries us is the corrosive effect on risk appetite stemming from fears of contagion from the European sovereign crisis.
Strong Asian and Latin American growth continues to be a key ingredient in our view that US exports and earnings will outpace domestic demand, and policy tightening there is consistent with the rapid rebound in the region. Indeed, we now see growth in both regions this year even stronger than just a couple of months ago. And the recent decision by China to revalue the renminbi has important implications: We think it means that Chinese officials won't tighten policy further, and it should at the margin promote global rebalancing and stronger export growth to Asia. Market participants have decisively turned up their nose at this move, possibly waiting to see whether China will deliver a meaningful move in the currency.
Looking backward, most surveys seem to evince little evidence of such uncertainty, at least through June. For example, measures of consumer confidence in June and the NFIB small business optimism index in May rose to two-year highs. In our view, analyzing such indicators using the time-honored business cycle metrics of depth, duration and dispersion suggest that the current recovery, while moderate, has staying power. The Fed's April Senior Loan Officer Survey showed a further easing in financial conditions; that is good news for growth. In contrast, the headline reading for our Business Conditions Index has plummeted in the past two months at the fastest pace on record. While forward-looking subcomponents of our canvass of analysts still point to healthy gains, the disconnect between those readings on one hand and the headline index and market sentiment on the other is disconcerting.
Looking ahead, however, uncertainty may depress those measures. To assess some of them, we update three metrics that might help to quantify uncertainty and its influence on the economy and markets: the gap between consumer expectations and current conditions; the residual between consumer sentiment and its determinants; and the extent to which real variables in recovery explain stock market volatility. Comparing our reading of these metrics last February with their current levels, none of them yet shows signs of deterioration that would trigger a change in view. But all three show deviations from the norm that testify to increased risks. In coming weeks, we will monitor these and other measures to validate our tentative conclusions.
Mind the sentiment gap. Surveys of consumer sentiment ask respondents how they assess current business conditions and their personal finances, plus their expectations for each of these over the next year or so. The gap between these two indexes is one simple measure of uncertainty or risk-aversion. For example, a persistently negative gap between current conditions and expectations would suggest a high degree of risk-aversion. At present, the gap between the index of current economic conditions and that for expectations compiled by the University of Michigan stands at plus 15.8 - about 3 points below the mean - but 11 points above year-ago levels when the economy was just starting to trough. The sign of that gap suggests that risk-aversion is not extreme, while the size of the gap suggests little change to uncertainty. However, this survey is flawed because it does not control for macro factors that account for fluctuations over the business cycle.
Model-based measure. A better gauge of uncertainty or risk-aversion is the extent to which measured consumer sentiment deviates persistently from what its key macro determinants predict it would be. Persistently positive errors in such a relationship suggest low uncertainty, while persistently negative errors indicate high (and possibly rising) uncertainty and risk-aversion. We estimated relationships using both the Michigan consumer sentiment index and the Conference Board's index of consumer confidence. These are not causal or behavioral relationships; rather, we are simply trying to control for cyclical factors. The relationships between these indexes and unemployment, stock prices, inflation, real income and home prices are close - explaining more than 90% of their variance - and the errors tell a consistent story. Those errors went sharply negative in the financial crisis, just as one would expect. And the errors in both equations went from strongly negative (up to 30 points) to or near zero as the crisis abated and as the new Administration took office, suggesting that risk-aversion declined.
Importantly, however, these measures have deteriorated even as the economy has improved over the past four months. That recent deterioration is echoed in surveys assessing opinions about government economic policy: The Michigan index of consumers' opinions of government economic policy has slipped about 25% since the euphoria recorded in the May 2009 canvass. In our view, this deterioration has not reached a critical level; it's still well above the lows of January 2009 and even turned up slightly in the past two months. But it bears watching.
Determinants of volatility. Volatility in equity markets is often viewed as a measure of uncertainty, but it arises from many sources. And parsing the sources of volatility is hard. To determine what kind of economic environment drives a high or low volatility market, our colleagues Sivan Mahadevan and Chris Metli have tried to determine how economic variables like the ISM drove volatility in the past six economic recoveries since 1970, using data from just after the market bottom in each recession through roughly one-and-a-half years after.
What's striking is that while economic factors helped to drive volatility lower over the past year-and-a-half, actual market volatility has itself been much more volatile than what economic variables alone would have predicted. We think that policy uncertainty and systemic risk increased market volatility: The model underpredicted volatility in the late 2008/early 2009 period when the global financial crisis was still unfolding, and then again in May 2010 during the height of the sovereign debt uncertainty (although the model did catch the recent uptick in direction, just not magnitude). Indeed, in our view, this underscores how much policy uncertainty can influence economic and financial market outcomes. So, while policy choices and results may be slow in coming, any reduction in uncertainty could play a constructive and self-reinforcing role for both.
Reducing policy uncertainty would be a plus. That uncertainty is a headwind to growth makes intuitive sense and seems to be borne out empirically. Recent work confirms this intuition, underlining how uncertainty produces negative growth shocks. Nicholas Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a decline in spending, hiring and activity. Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy stimulus. That's because the uncertainty can swamp the effects of lower interest rates, transfer payments or tax cuts. In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as uncertainty declines, the threshold falls with it. That squares with our long-held view that policy traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through much of last year, but improved as uncertainty fell.
These results suggest that reducing policy uncertainty now could be a tonic for growth. That won't be easy or come quickly at home, given the political backdrop in this election year. Nor will it be simple in Asia, given the need to reduce policy stimulus, or in Europe, given the depth of the fiscal problems faced by the countries on the periphery. But even some incremental clarity on policies in any of these three theatres would offer investors a chance to assess the fundamentals again - fundamentals that we still see as improving.
Over the past few weeks, concerns related to the fiscal condition of state and local governments in the US have intensified. In particular, the price of credit default swaps on a basket of benchmark municipal bonds (MCDX) has risen even more than the CDS on European sovereign debt.
Before we attempt to assess the magnitude of the problem confronting the municipal sector, some background might be helpful. Government finance at the state and local level works differently than at the federal level. For example, most states and municipalities are required to balance their operating budgets - or to at least enact a balanced budget. Obviously, there is no such requirement at the federal level. Moreover, the federal government does not distinguish between operating funds and capital investments. To be sure, the balanced budget requirement for many states is not quite as strict as it might appear. Almost half of the states allow deficits in their operating budgets either to be carried forward to the next year or to be covered through borrowing. Also, states carry ‘rainy day' or reserve funds that can be drawn upon to cover short-run deficits. Still, because there is greater pressure to at least attempt to balance the budget at the state and local level, deterioration in the fiscal environment will likely lead to announcements of spending cuts and/or tax increases of the sort seen in recent press reports.
How did they get into this mess? The bulk of the recent deterioration in state and local government finances is attributable to macroeconomic cyclical forces. As I looked through one of my dusty old files on the subject, I came across press clippings with headlines virtually identical to those of today. The only difference - they are all about 10 or 20 years old, having been published shortly after the 2001 and the 1990-91 recessions. And, it's no coincidence that the New York City fiscal crisis in 1975 followed on the heels of one of the most severe national recessions in the modern era. This time round, the situation is serious and widespread, but that largely reflects the fact that the recent economic downturn was far more severe than the 1973-75, 1990-91 or 2001 recessions. The bottom line is that the business cycle is largely to blame for the fiscal imbalances currently being faced by states and municipalities - as is usually the case.
The main driver of state and local budget pressures is a fall-off in income taxes, consistent with our cyclical story. For example, the growth rate of personal income taxes - which comprise a little less than 15% of state and local government receipts - has swung from about +10% per year during the 2004-07 boom to -19% in 2009 (note that 43 states and a handful of cities currently impose some form of a personal income tax). Even so, S&L personal tax revenue has held up much better than at the federal level, where there was a swing from a +11% growth pace during the 2004-07 period to -6% in 2008 and -25% in 2009. In fact, the deterioration in overall tax revenue has been much less severe at the state and local level. This is largely attributable to the relative importance of sales taxes and property taxes, which together account for nearly 40% of state and local government receipts. Sales taxes have dipped in recent years, but not by nearly as much as income taxes. And, despite the widespread weakness in real estate markets, property taxes have continued to edge higher as many municipalities have adjusted tax rates to offset the decline in property values. Moreover, support from the federal government (which accounts for about 25% of S&L sector receipts) continues to grow rapidly. In fact, grants from Washington to the states have been rising at about a 20% annualized pace since the passage of the fiscal stimulus legislation (ARRA) in February 2009, helping to prop up S&L spending.
How big is the problem? There is no question that the fiscal position of state and local governments is poor. The accompanying figures highlight the recent deterioration in operating budgets and the draw-down in reserve balances. However, it's worth noting that the swing in the budget picture pales in comparison to the federal sector. That's because the federal government has a much larger and more volatile revenue base - and because the federal government has been providing a significant amount of support to the states. While tax inflows have inched a bit lower in the state and local sector of late, they have plummeted at the federal level. Measured on a National Income and Product Account (NIPA) basis, the state and local government budget deficit actually improved from $40 billion in calendar 2008 to $19 billion in 2009, as grants from the federal government to states and municipalities more than offset the declines in their tax receipts. At the same time, the federal government deficit (on a NIPA basis) grew from $640 billion in 2008 to $1.2 trillion in 2009.
Meanwhile, the tax increases and spending cuts that have been enacted at the state and local level in an effort to try to rein in budget gaps have been relatively modest when gauged against an overall $14 trillion economy. In its June report, the National Conference of State Legislatures (NCSL), an organization that compiles budget figures for all the states, estimated that states enacted revenue changes of $24 billion in F2010 (note that the state fiscal year runs from July to June). The NCSL report indicates that another $3 billion of tax hikes have already been proposed for F2011. This includes about $1.5 billion of higher taxes in the state of New York attributable to a hike in the excise tax on cigarettes and a new tax on soft drinks.
Despite cutbacks, spending is rising. On the spending side, there have been significant cutbacks in some discretionary categories that attract a good deal of media attention, but overall expenditures are now rising at a modest pace. The Medicaid program warrants special focus. Medicaid is a means-tested entitlement program financed jointly by the states and federal government, which currently provides medical care to 60 million low-income individuals. The program accounts for a little more than 20% of total state spending at present. Enrollment growth has been accelerating in response to the recession, and thus overall Medicaid outlays jumped by an estimated 10.5% in F2010. However, the ARRA stimulus program provided significant Medicaid-related support to the states by raising the federal government's contribution share. The ARRA funding for Medicaid during the 2009-10 interval amounts to a little less than $100 billion. This went a long way towards holding down the states' contribution. But the extra support from the Federal government is slated to run out at the end of 2010. If no action is taken, the burden on the states will rise dramatically in coming years. As a result, many states are on the verge of implementing Medicare cost containment plans that include cuts in doctor payments, benefit limitations, higher patient co-payments, etc. Moreover, many states are fearful that the recently enacted healthcare reform will lead to additional Medicaid-related costs when it goes into full effect in 2014.
Pension funding poses long-term challenge. Of course, state and local governments also face looming pension challenges that are likely to lead to ongoing pressures on operating budgets in the years ahead. In fact, the Pew Center on the States (a well-respected think tank) reports that pension obligations are less than 80% funded in 21 states. Moreover, many states appear to be relying on overly optimistic assumptions that make their funding status appears better than it actually is. For example, the state of California reports that its plan is only about 13% underfunded at present. But Pew estimates that applying a 6% discount rate (as opposed to the actual assumed rate of 7.75%) would lead to an underfunding of $82 billion - more than double the reported $35 billion shortfall.
Federal financial impact outweighs the state and local one. Even after taking into account all of these headwinds, the macroeconomic impact of fiscal policies at the S&L level pales in comparison to the potential impact of changes at the federal level. For example, we estimate that there would be about $200 billion of fiscal drag in 2011 if the 2001 and 2003 federal tax cuts are allowed to expire as scheduled at the end of the current calendar year. If Congress adopts the Obama Administration's proposal to extend the cuts for families with less than $250,000 of income (as assumed in our current forecast), the associated fiscal drag in 2011 will be reduced to about $75 billion. By comparison, state and local budget cuts likely will amount to a few billion dollars in F2011 (a July-to-June fiscal year) - assuming that Congress approves an extension of Federal Medicaid assistance to states. Thus, the outcome of the federal tax debate represents a far greater source of macroeconomic impact than anything that happens at the S&L level over the next year.
Continued economic growth is key to near-term outcome. Although the fiscal situation at the state and local level represents an obvious potential headwind for the national economy, swings in federal government finances are generally far more important from an overall macro perspective. If the economic recovery in the US were to stall, budget woes at all levels of government would intensify, and the inability of the state and local sector to run large-scale operating deficits would lead to another round of tax hikes and spending cuts. But if the national economy continues to recover as we anticipate, the near-term fiscal condition of the vast majority of state and local governments should begin to improve.
With investors increasingly lengthening their outlook on how long the Fed's "extended period" of zero rates will last, and interest rate market volatility grinding steadily lower, continued movement by investors into carry and roll-down positions led Treasuries to a week of solid gains, led by the intermediate part of the curve, and also drove the mortgage market to extend an excellent recent run in keeping pace with the Treasury gains to send MBS yields and mortgage rates towards record lows. After a fair amount of recent press and market chatter about the FOMC possibly announcing some sort of dovish shift, in the event Wednesday's statement was uneventful. There were tweaks to the opening paragraph in line with the somewhat more mixed tone of the incoming data and the tightening of financial conditions resulting from the European debt turmoil and also a mention of the recent decline oil downtrend in core inflation. There was no change to the forward-looking parts of the statement, but the overall tone was enough to add to building investor sentiment that the Fed could be on hold for a lot longer than was thought likely not too long ago. If the Fed's not going to move for most of the next two years - not our expectation, but a view that is becoming increasingly widespread in the market with the Fed's implicit consent - then the 0.738% yield at which the new 2-year note was awarded on Tuesday could very well end up looking cheap in retrospect. And if interest rate volatility is going to remain as muted as it recently has been or even extend its persistent recent downtrend and inflation is not going to be a problem in the foreseeable future - both of which are potentially risky but it seems also increasingly widespread investor assumptions that have also both been boosted by Fed rhetoric - then a 5-year at 2% or 10-year at 3% could also eventually be seen as not having been expensive. Internal rates markets' dynamics of falling volatility, increasingly dovish Fed expectations and resulting rising demand for carry and roll-down positions have been the main drivers of upside recently. But certainly the previously extremely high correlation with risk markets hasn't been completely broken, and a poor showing through the week by equity and credit markets was supportive. Sovereign credit fears remain an important background risk factor weighing on stocks and credit and supporting credit, and investor attention to a notable extent over the past week started to shift somewhat towards the fiscal situation of American states on top of ongoing concerns about Europe. Indeed, while Greece came under some pressure during the week, much more important in Europe at this point is the fiscal and funding position of Spain, and Spain's yield spreads over Germany narrowed slightly for the week. On the other hand, the muni bond MCDX index widened substantially over the course of the week to a series of new wides for the year and the pressure was not getting better on Friday when the two widest individual states, California and Illinois, were seeing big further widening moves going into the weekend. Meanwhile, the economic data calendar the past week was light but positive in what mattered. Housing numbers were weak but we knew housing was going to be weak after the expiration of the homebuyers' tax credit. On the other hand, the durable goods report was significantly better than expected and pointed to continued strength in business capital spending, leading us to raise our 2Q GDP forecast to +4.0% from +3.6%.
On the week, benchmark Treasury yields fell 9-15bp, with the 5-year leading notwithstanding a terrible 5-year auction Wednesday. After a brief bit of opening weakness Monday in response to China's weekend currency shift, there was an almost non-stop rally from mid-morning Monday until early on Thursday before a bit of late week consolidation. And even then, a wave of buying hit the market Friday morning as soon as Thursday afternoon's modest sell-off was slightly extended, moving Treasuries sharply back up and reversing what had been a bit of opening softness in mortgages. For the past couple of weeks, this real money buying on any weakness of note has been persistent. For the week, the old 2-year yield fell 9bp to 0.63%, 3-year 14bp to 1.07%, old 5-year 15bp 1.87%, old 7-year 13bp to 1.56%, 10-year 11bp to 3.11% and 30-year 9bp to 4.07%. The bill market started to get squeezed pretty badly a couple of weeks ago, but Treasury stabilized the situation by keeping issue sizes elevated for the second half of June (a seasonally positive cash flow period). The 4-week bill yield rose 1bp to 0.04% and 3-month 3bp to 0.13%. It's possible there could be some unusual short-term moves in coming days, and liquidity broadly will probably not be great, ahead of quarter-end. The overnight Treasury general collateral repo rate averaged 0.18% Friday and at this point is trading at 0.02% for June 30, though it certainly could swing negative again as it has around recent quarter-ends. The initially quite positive reaction to China's decision to de-peg the renminbi from the dollar faded quickly in a lot of markets, but there was some lingering support for commodity prices that helped TIPS somewhat on the week. China's demand is most important for metals, and the LME's base metals composite jumped 4% on the week, while front-month oil saw a more muted 1% rise. Short-dated TIPS inflation breakevens held in pretty well with this support, but the benchmark issues lagged a fair amount. Especially at the longer end, real yields have reached such low levels - not too far from the historical lows just below 1% for 10s hit in March 2008 - that further declines may be increasingly hard from here. On the week, the 5-year TIPS yield fell 7bp to 0.24%, 10-year 4bp to 1.15% and 30-year 1bp to 1.74%.
Interest rate volatility fell steadily through the week, cumulating to a substantial drop back towards the year's lows, which was supportive both of the ongoing Treasury rally and also a continued impressive performance by mortgages, with current coupon MBS yields approaching all-time lows - which still represented what was perceived by many investors to be a fairly safe opportunity to pick up some extra yield over Treasuries. Normalized 3-month X 10-year swaption volatility was a bit below 100bp by late Friday, a 9bp drop on the week. This measure of volatility ended last year near 125bp after having peaked in 2009 over 200bp in June. It is now back not far from the lows for the year, a bit below 90bp hit in March - which was the lowest level seen since late 2007 - after having only seen a move back up to as high as about 120bp in early May and then again in early June during the recent European debt strains and related broader market turmoil that saw a much more severe spike up in equity market volatility. With this supportive backdrop, the MBS market continues to do very well. On the week, Fannie 4% MBS outperformed Treasuries by a few ticks to take current coupon MBS yields down to new lows for the year and nearly all-time lows (only a few days in early 2009 were lower) just above 3.8% at Friday's close. This took the average 30-year conventional mortgage rate down to a record low 4.69% this week according to Freddie Mac's survey and should see it moving lower again in the coming week if rates MBS yields stay near current levels. Normally such a low level of mortgage rates would be driving a much higher pace of refinancings than we are currently seeing (though, encouragingly, origination activity did start to pick up notably late in the week as the market hit new highs), but because of widespread negative equity and generally tighter credit standards, refis have picked up but not nearly as much as they did in say 2003, when there was an epic refi wave with what in retrospect looks like a notably less impressive rate move. This, in turn, feeds back and supports the volatility story, since if there is a lot less prepay activity in mortgages than would normally be expected, big holders of mortgage-backed securities increasingly adjust their models and stop buying as many volatility hedges.
While the run of a month or so in which Treasury yields and stocks were moving in lock-step in day-by-day and intraday trading has broken down more recently to a significant extent, the steady Treasury rally through most of the last week after opening weakness Monday was largely mirrored by a soft showing by stocks, with the S&P 500 ending down 3.6%. The energy and consumer discretionary sectors performed worst, while financials saw the smallest drop after a good rally Friday as the financial reform neared final passage, removing a major cloud of uncertainty. This Friday upside in financials helped the investment grade CDX index end the week on a particularly positive note, with a 6bp tightening Friday to 114bp, cutting the widening for the week to only 4bp. Prior to this rally, IG CDX investors had been increasingly disturbed by a terrible week for the muni bond CDS, which is starting to become a point of concern broadly across markets. In late trading Friday, the 5-year MCDX index was almost 40bp wider on the week at about 250bp. Prior to this week, it had been holding steady near 211bp for a couple of weeks, which was the high for the year but it was at least looking stable. But then it suddenly moved much wider Monday afternoon and continued deteriorating through the week. The move in the overall MCDX index was also seen in bigger moves in the two widest states already at the start of the week, with California ending Friday near 350bp and Illinois near 360bp after widening about 50bp each on the week. This is an area where investors are starting to focus more attention recently but there is a lot of confusion. As a stark example, the press sometimes tosses around casual comparisons of, say, Greece to California, but then many investors are shocked to hear that California's debt to GSP (gross state product) ratio looking at general obligation debt is only about 4%. On the other hand, long-term pension and related obligations at the state level in many cases do look extremely daunting, and while the requirement of having a (more or less within some fuzzy definitions sometimes) balanced operating budget every year doesn't allow the build-up of massive debt overhang, it does create these repeated issues of states not being forward-looking enough and spending too much and cutting taxes when times are good and adding unhelpfully to expansions and then having to turn around and raise taxes and slash spending when the economy is weakening. Going forward, however, from an economic perspective we expect the further state government fiscal consolidation to be economically quite minor as far as overall fiscal stimulus or contraction compared to the federal outlook (see David Greenlaw's June 25 note, US Economics: State and Local Fiscal Problems: How Big a Headwind?).
It was a light week for economic data, with better-than-expected results in the durable goods report and the positive implications this had for capital spending the most notable news. Prior to that report, the housing market figures extended the fully expected payback from the boost in sales and (to a much lesser extent) construction seen ahead of the April expiration of the homebuyers' tax credit, with new home sales, which are based on contract signing, plummeting in May after the previously reported drop in May housing starts. Existing home sales, which are based on closings, were also a bit weaker, but at least according to the NAR there is a very large backlog of existing sales contracts that should qualify for the tax credit that are facing delays with closings. If these can be worked through, existing home sales should see some follow-through upside before a more severe delayed pullback down the road.
The more notable new information during the week was the strength in the durable goods report, which pointed to ongoing momentum in capital spending and less of a near-term pause in the inventory cycle, leading us to boost our 2Q GDP forecast to +4.0% from +3.6%. This would mark a significant acceleration from the slightly downwardly revised +2.7% (versus +3.0%) increase in 1Q as BEA revised services consumption lower. The pick-up in final demand looks far more robust, as we see final sales (GDP ex inventories) growth accelerating to +4.3% in 2Q from +0.8% in 1Q and final domestic demand (GDP ex inventories and trade) to +4.2% from +1.6%. We look for upside in business investment to account for a good portion of this solid 2Q growth. Durable goods orders fell 1.1% in May but only because of pullbacks in the volatile civilian aircraft and defense capital goods categories. Non-defense capital goods ex aircraft orders, the key core gauge, jumped 2.1% and smoothing through what has become some typically extreme volatility around quarter-end the past couple of years in March and April were up at a 26% annualized rate the past three months. Upside continues to be led by machinery bookings, which surged 5.6% in May and 50% annualized the past three months. Core capital goods shipments also extended a strong trend, rising a better-than-expected 1.6% in May. Incorporating this result, we boosted our forecast for 2Q equipment and software investment to +14% from +11% and for overall business investment to +11% from +9%. This would mark a major acceleration for overall business investment from +2% in 1Q, with an expected swing to small growth in the structures component after an extreme run of seven straight quarterly declines that cumulated to a 30% drop, adding to the continued momentum in the larger equipment and software component. We'll get more information on structures investment in the May construction spending report this week after a surprising surge in business construction reported for April.
The upcoming week's economic calendar is fairly busy ahead of the July 4 holiday week, with focus on the key early reports for June - employment on Friday and ISM and motor vehicle sales Thursday - which we think will continue to show solid results. Other releases due out include personal income Monday, consumer confidence Tuesday, construction spending Thursday and factory orders Friday:
* We look for a 0.5% rise in May personal income and a 0.1% uptick in spending. Even though private job growth was disappointing in May, the labor market report showed that average hourly earnings posted a solid rise, and the length of the workweek increased. So, the bottom line implications of the data for personal income were quite positive. Meanwhile, the retail sales data point to only a fractional rise in consumer spending for the month of May. The combination of solid income growth and a more modest spending gain means that the personal saving rate should see some further recovery from the low point seen in March. Finally, we look for a 0.13% rise in the core PCE price index, which would keep the year-on-year rate steady at +1.2%.
* We expect the Conference Board's measure of consumer confidence to be little changed at 63.0 in June. The University of Michigan gauge posted a surprising uptick in early June but has actually been reasonably steady through the first half of the year. In contrast, the Conference Board index has registered significant gains off the February lows in recent months. So, it has already shown much more of a recovery than the Michigan barometer. In June, we look for the Conference Board index to hold near the 63.3 reading that was registered in the prior month, as the impact of falling gasoline prices is about offset by financial market turbulence.
* We expect the ISM to fall only slightly in June to a still lofty 59.0. The regional reports released so far have been stronger overall on an ISM-weighted basis. But the national index has been running higher than the regional averages recently. So, we expect to see some catch-up and look for a bit of slippage in the ISM relative to the 59.7 seen in May. Also, the regional results suggest that the recent slide in commodity prices - especially within the energy complex - will show up in the price gauge this month.
* We look for a 0.6% pullback in construction spending in May following the surprisingly sharp - and broadly based - advance seen in April. Specifically, the housing starts figures point to some slippage in residential activity. Also, we look for renewed deterioration in the non-residential category. However, a further rise in the public sector should offset some of the decline in private activity, as infrastructure projects finally appear to be ramping up.
* We estimate an 11.2 million unit rate of motor vehicle sales in June, as industry surveys suggest that June sales pace will be a bit below that seen in recent months despite an anticipated pick-up in fleet activity. Lean inventories and depressed levels of consumer sentiment continue to weigh on sales. However, we still look for a modest pick-up in demand during 2H10, which should bring overall sales to about 12.0 million units for the year.
* We forecast a 90,000 decline in overall non-farm payrolls in June. The Census Bureau reported a roughly 240,000 decline in temporary workers during June. So, we should see an outright decline in the headline payroll figure in this report. But, of course, the main focus should be on non-census employment. We continue to believe that the combination of unusually favorable weather and the timing of the survey period helped to boost job growth in March and April and that the slippage in May represented some payback for these special factors. Thus, we see the underlying trend in payroll growth running near +150,000 over the past few months and look for a similar outcome in June. Meanwhile, the start of the unwind in census employment should contribute to a slight uptick in the unemployment rate. As discussed previously, we calculate that under the extreme assumption that all census workers are job finders (i.e., individuals previously counted as unemployed), the impact on the unemployment rate would be about -0.50pp. Under the more realistic assumption that about one-third of the workers are job finders, one-third are new entrants and one-third are multiple job holders, the peak impact on the unemployment rate should be about -0.15pp. Finally, note that the average workweek and hourly earnings figures exclude the public sector and thus are unaffected by the influx or departure of census workers. The average workweek has been moving steadily higher in recent months but appears due for a bit of a pause at some point.
* We look for a 1.1% decline in May factory orders. The previously reported decline in the durables component, which was accounted for by pullbacks in the volatile civilian aircraft and defense capital goods categories while core capital goods orders posted good upside, and an expected price-related decline in non-durables should lead to a decent pullback in overall factory orders.
We see a decent chance that the NBP changes its tone this week: After moving to a neutral bias and adopting a wait-and-see stance last October, we think that the risks are tilted towards a move to a more hawkish stance, in preparation for rate increases later this year. We see risks that this happens already at the next meeting, on Wednesday, June 30, when the NBP also releases its new CPI projection. We believe that markets are not prepared for a move to a more hawkish tone, which could take the form of either an explicit tightening bias in the statement or some post-meeting commentary by rate-setters. There are four main factors that inform our view: the strength of recent data, the zloty, the June CPI forecast and the recent commentary from the MPC. We go through each of these in turn and then focus on the risks to this view.
Data have surprised on the upside, labour market is healing fast: The recent data releases have uniformly surprised to the upside. IP growth reached 14%Y in May, much higher than expectations (Bloomberg: 7.9%). On a workday-adjusted basis, the rise was smaller, but still in double-digit territory (10.9%Y). IP has now risen on a sequential (month on month, sa) basis every month this year except for April, and the 3m/3m annualised rate stands at a whopping 16%. The last time the Polish industrial sector was positing such strong increases in output was in early 2008, at the peak of the previous cycle. Retail sales growth was more muted, at 4.3%Y in May, but still better than expected (Bloomberg: 3.3%Y). In volume terms, retail sales are rising at a 3% annualised clip (3m/3m), not as stellar as IP but fairly solid. But the real news is in the labour market, we think: the economy has been adding jobs for three months, taking the year-on-year rate of employment growth to 0.5%Y in May; wage inflation has also risen, up to 4.8%Y in May. And the jobless rate has now fallen for three consecutive months (May: 11.9%), only in part due to seasonal factors.
The zloty: Less of a worry: In April this year, the NBP moved away from its long-established no-intervention policy and intervened in the FX market to stem zloty appreciation. We have interpreted this shift as an opposition to the pace of appreciation, rather than appreciation per se (see CEEMEA Macro Monitor, April 26, 2010). Indeed, several senior policymakers, including Governor Belka himself, have argued that the medium-term case for zloty gains is compelling. In any case, fears of zloty appreciation have surely receded now: the recent moves have erased currency gains versus the euro since the start of the year. And on a trade-weighted basis, the zloty is around 5% weaker than at the start of the year (due to USD gains). Given that this MPC seems to be quite sensitive to FX moves, the recent zloty weakening gives it more room to contemplate tighter policy.
June inflation forecast: another increase? The February CPI forecast was certainly not a benign one: the projection showed inflation bottoming at around 1.5%Y this summer and then rising steadily, to reach 4% by end-2012, under the assumption of unchanged rates. Indeed, with such a steep rise in the inflation projection over the monetary policy period (1-2 years), it may look surprising that the NBP did not adopt an outright tightening bias. This may have been due to two reasons: first, the forecast does not enjoy the same status for the NBP as it does for, say, the CNB. In other words, it is ‘just' an input in decision-making. Second, the bank probably did not have enough confidence in the outlook to change its stance in a meaningful way. What has happened since then? First, the growth outlook seems more entrenched, as shown by both the 1Q GDP data and the recent high-frequency releases. Second, the inflation projection is unlikely to be lower: if anything, it may well be revised higher, on the back of elevated energy price assumptions. Core inflation has been slowing, but the recent zloty weakening may feed through in the coming months. And of course, the floods may have an adverse impact on food prices. Again, we stress that the NBP is not as reliant on its forecast as others. But at least, these forecasts should be pointing in the direction of a tighter policy stance.
MPC commentary has turned more hawkish, too: It was interesting to see some MPC members turn more hawkish lately. Zielinska-Glebocka and Glapinski both argued for a 50bp rate hike in the autumn, though it is unclear how many members share that view. The impact Belka's first meeting as governor may have on the Council is also an unknown, of course.
Risks: Too early to change tone? Inflation is still slowing, and unlikely to trough for another two months (July). Therefore, some on the MPC might be reluctant to change bias or tone, especially if they are as focused on contemporaneous inflation as the bulk of the previous MPC was. In addition, the outlook for the euro area remains shaky and some on the Council might be reluctant to signal rate increases so far ahead of any ECB tightening. However, on these points, we note that the trouble with the euro area economy is mostly at the periphery, which matters little to Poland. The German macro outlook is by far the most important variable for the Polish economy, and we note that our euro area colleagues revised up their 2010 GDP forecast from 1.4% to 1.9%. Also, the May minutes showed that, while some members observed that the ECB would be unlikely to raise rates until next year, others pointed out that the "parameters of monetary policy may change earlier in Poland than in the developed economies". The debate is therefore already very much alive.
Bottom line: We continue to look for rate increases (50bp) before year-end. The MPC is likely to gradually prepare the grounds for those, by changing the language and/or the bias in advance, we think. The June meeting provides such an opportunity, in our view. Even if the bias is left unchanged, we expect the tone of the communiqué to sound more hawkish than in previous months.
If the globe is about to face a growth relapse, Argentina is unlikely to be immune. However, despite risks of another downturn, we suspect that Argentina watchers should not lose sight of two issues. First, we estimate that Argentina's liquidity cushions exceed their financing needs for the next 18 months. Second, we see a secular medium-term case for Argentina that rests on three pillars: a return to international capital markets, a change in policy direction and solid macro fundamentals. These two factors are unlikely to protect Argentina in the near term against a potential global growth relapse, but they should inform market perception of Argentina's country risk.
The Near-Term Cushion
If the experience of the past two years is any guide, in the case of a global growth relapse market concerns regarding Argentina's ability to service debt may intensify. After all, back then the risk premium on Argentina's debt skyrocketed as the fiscal surplus turned to deficit. However, the fears proved unfounded as Argentina remains current on its debt obligations. How sensitive are Argentina's finances to a growth downturn?
Read Full Article »