Inflation bottoming, but slower rise. Nonetheless, we are lowering our forecast trajectory for inflation, which means a later exit for the Fed and a lower trajectory for long-term yields. We still think inflation has bottomed, but the acceleration next year will likely be slower - to 1.75% for core CPI versus 2% previously.
The lower inflation trajectory carries implications for the Fed and yields:
• With lower inflation next year, we see the Fed waiting until 3Q11 to move. Previously we expected a move by the end of 1Q. And once it starts, the move will be gradual, so the funds rate should end 2011 at 1% instead of 1.75%.
• Likewise, for 10-year yields, we see a slower rise than before - to 4.5% instead of 5% by end-2011. Two factors mean the yield curve will likely remain comparatively steep even when tightening begins: Reactive Fed policy will nurture higher inflation risk premiums, and the supply-demand balance in credit markets will tip real yields higher.
Two point four: barely sustainable. The deceleration in GDP growth from 5% in 4Q to 2.4% in 2Q has reinforced the consensus outlook for sluggish, below-trend growth. Extrapolating that deceleration, many believe that 1-2% growth in 2H is a given.
We agree that 2.4% growth lies barely on the threshold of a sustainable economic recovery: It is just fast enough to generate the jobs and hours needed to extend income growth for moderate gains in consumer spending. But it is not fast enough to continue to narrow slack in the economy - key for reducing the tail risk of deflation and maintaining operating leverage for corporate profits. So a pickup in both demand and output are critical to assure self-sustaining growth.
Four factors driving a pickup. The current deceleration in economic activity is largely a reaction to the spring shock from the European sovereign credit crisis. That shock had a bigger impact on US growth than we thought earlier this year, because it triggered a sudden, temporary tightening in financial conditions and increased uncertainty about the sustainability of global growth.
But four factors are likely to promote improvement: 1) Financial conditions have eased again, 2) global growth will contribute to US growth, 3) domestic demand and income gains are gradually firming, helped by accelerating infrastructure outlays, and 4) the inventory cycle is not over.
1. Financial conditions have eased, with the capital markets opening again and risk appetite returning. High yield and investment grade corporate spreads widened significantly this spring, but rates have since declined in absolute terms to record lows. Conventional, 30-year mortgage rates have plunged by 70 p. The dollar on a broad-trade-weighted basis has reversed its spring rally. And stock prices have reversed about half their swoon since April.
2. Global growth is still hearty. For example, it appears that the Chinese economy has slowed in response to restraints on lending and tighter monetary policy. But we estimate that it is slowing from 10% this year to 9.5% in 2011 - still strong. So while net exports sliced 2.8pp from 2Q growth in the US, we think they are poised to improve dramatically. The sharp widening in the US trade gap in 2Q did not reflect weak exports; they rose at a 10.3% annual rate, even though weak agricultural exports trimmed the gain. The drought in Russia and bumper US inventories will probably combine to boost farm exports in 2H. More important, the 35% annualized merchandise import surge in 2Q was a temporary anomaly, in our view. The jump in oil imports seems to reflect one-time offloading of crude cargoes from ships on the water to tank farms, and the surge in consumer and automotive imports probably will unwind quickly, as it far outpaced the swing in inventories and final sales.
3. Modest but sustainable gains in domestic demand. Domestic final demand accelerated to a 4.1% clip in 2Q. A significant slowing is underway; indeed, we see it correcting to just over 2% in 2H. But that lower pace should be more than sustainable. Among the reasons:
• Despite tepid July employment data, gains in the workweek and wages still seem likely to yield annualized gains in real disposable income of 3%-plus in 2H; that is more than sufficient to sustain both 2-2.5% consumer spending growth and a further rise in the personal saving rate. Indeed, sharp (2pp) upward revisions to the personal saving rate over the past two years to 6.2% hint that consumers have rebuilt saving and balance sheets by paying and writing down debt - deleveraging - by more than previously thought. Consequently, the headwind to consumer spending from deleveraging is a smaller risk to the outlook as consumers can spend more of their income in 2H.
• The extension of unemployment insurance benefits and aid to state and local governments, restoring $60 billion in temporarily-suspended fiscal stimulus, should add to incomes and confidence. That would especially be the case if state and local governments use the funds to rehire the 48,000 workers furloughed in July as the fiscal year began. Moreover, we expect that Congress will agree to extend many, if not all, of the tax provisions that expire on December 31 for one year. While that could generate uncertainty about tax policy, it should avoid near-term fiscal drag.
• Profit margins have yet to peak, providing wherewithal for capital spending, and companies have begun to invest to replace worn-out and obsolete equipment in a sustainable way.
• Finally, infrastructure spending, the last part of the fiscal stimulus enacted in 2009, is now gathering steam. Double-digit spending gains for infrastructure should offset any further weakness in local government hiring.
4. The inventory cycle is not over. While outsized contributions to output from inventory accumulation are unlikely, inventories have become exceptionally lean in relation to sales. Notwithstanding the secular decline in inventory-sales ratios resulting from just-in-time inventory management techniques, if we're close to right that overall final sales (including net exports) run at a 3% rate, inventories will fall too low in some industries unless production steps up in tandem. As further evidence, the ISM manufacturing customer inventory index at 40 is well below historical norms.
There continue to be two key risks to our moderately upbeat scenario:
1. Housing. In addition to the ‘payback' following expiration of the first-time homebuyer tax credit, the downside risks to home prices, mortgage credit availability and housing demand are still present.
2. Policy/political uncertainty. We think that increased uncertainty around taxes and implementation of healthcare and regulatory reform is one reason why consumer confidence slipped in the last couple of months.
The case for a gradual rise in inflation. Firming rents and narrowing slack reinforce our conviction that inflation is bottoming and that the deflation scare is just that - a scare. Evidence for rising rents began accumulating late in 2009, as apartment vacancies fell. From January through May, rents climbed 2.8% nationwide, according to Axiometrics, which tracks the national apartment market. Those increases move through the popular price gauges like the CPI on a six-month moving average basis, so the increases seen in May and June likely will persist.
Thanks to hearty gains in output and cutbacks in capacity, moreover, operating rates have jumped 580bp from their trough; that's long been a key factor behind our above-consensus inflation call. The idea that ‘speed effects' - or changes in slack - as well as its level have an impact on inflation is controversial and difficult to pin down empirically, although it makes intuitive sense. The notion is that a trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses' and consumers' outlook for the factors that drive inflation. It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery. Consequently, speed effects are strongest for wholesale or producer prices, but we believe that they matter for consumer prices as well.
Looking ahead, the coming rise in inflation will likely be slower than we had been thinking, courtesy of smaller declines in capacity and thus smaller speed effects. The strong gains in capital spending seen since the start of the year are offsetting ongoing cuts to industrial capacity, which declined 1.6% since late 2008; capacity just began to level off in 2Q. As a result, we now see core inflation measured by the Fed's preferred gauge (the PCE price index) at 1.8% in 2011, about 0.4% higher than its pace over the past year but a quarter-point below our earlier forecast.
Resetting the timetable for a reactive Fed. Near term, the deceleration in growth and risks of further declines in inflation could spur the Fed to take out double-dip/deflation insurance. Indeed, policymakers may be close to adopting a change in the reinvestment policy for their portfolio of MBS, reinvesting the cash flows associated with principal repayments of MBS into Treasuries instead of letting the portfolio run off.
A change in the reinvestment policy would be aimed at avoiding a passive shrinkage of the Fed's balance sheet. Although the Fed's buying program ended in March, its portfolio of MBS has just started to contract, because a significant portion of the purchases were for forward settlement. The settlement of these transactions has just about offset the impact of prepayments, and the Fed's overall MBS holdings have remained fairly steady. However, almost all of the forward trades had settled as of the end of July, so the underlying shrinkage in the principal balance should now start to become more apparent, absent any new action. Even though prepay speeds are slower than would be expected, given the current rate environment, our trading desk estimates that prepayments will lead to about a 2% per month decline in the Fed's MBS portfolio going forward. On a base of $1.12 trillion of holdings, that amounts to about $20 billion per month.
In light of today's weak jobs report, we suspect that the FOMC will adopt the reinvestment change at its meeting next Tuesday. From our standpoint, it would make a lot of sense to combine a Fed reinvestment program with measures aimed at streamlining the mortgage refinancing process (as outlined in Slam Dunk Stimulus, July 27, 2010). However, the Fed does not really have any authority over the GSEs or the mortgage origination process; that would be up to the Federal Housing Finance Agency and the Treasury Department. Currently, the motivation for a change in the Fed's reinvestment policy seems to be merely to avoid balance sheet shrinkage.
The MBS market is still feeling the effects of the Fed's massive buying - fails are running near historical highs and liquidity is abnormally low. Thus, we suspect that the Fed would buy Treasuries, rather than MBS, if it does decide to reinvest the principal repayments. And it would probably concentrate its buying in the short-coupon sector, since that would make for the easiest exit strategy, thereby appeasing the hawks on the FOMC.
Looking ahead, with a lower trajectory for inflation next year, we see the Fed - already reactive and wanting to be very sure of sustainable growth and a return of inflation to the comfort zone - waiting until 3Q11 to move. Previously, we expected a move by the end of 1Q. Once it starts, the move will be gradual, so the funds rate will likely end 2011 at 1% instead of 1.75%. To be sure, that's not the end of the story. Our guess is that growth will be stronger and rates will rise more significantly in 2012.
Reactive policy = rising term premiums. Likewise, for 10-year yields, we also see a slower rise than before - to 4.5% by end-2011 instead of 5%. That's a steep rise from current levels and, for the yield curve, a break from the bull-flattening move that began with the onset of the European sovereign debt crisis and was extended by the deceleration in US growth. At work will be the combination of a reactive Fed and rising real yields, which suggests that the yield curve will remain comparatively steep even when tightening begins. With the real funds rate still negative and inflation moving up, a reactive, cautious Fed means that term premiums are likely to rise, and the yield curve will flatten modestly at best. As the Fed is expected to tighten later and more slowly than before, we think the yield curve will only flatten slightly and 10-year yields will rise to 4.5%.
The last point is worth emphasis: We think the inflation risk premium will be higher because, unlike the past, the Fed will be reactive rather than proactive. That's a critical reason why the curve should stay steep despite rate hikes - a point of differentiation for our call.
For full details, see Growth Pickup Coming, but Less Inflation Means Delay in Fed Tightening, August 6, 2010.
Treasuries posted decent further gains in the intermediate and short ends of the curve over the past week and small losses in the long end after the weaker-than-expected employment report led investors to continue pricing out any significant Fed tightening for a very long time and moving into the parts of the curve that look most attractive on a carry and rolldown perspective in such a scenario. At Tuesday's FOMC meeting, there reportedly will be a focus on deciding what, if anything, to do about principal repayments on the Fed's huge portfolio of mortgage-backed securities, which peaked a few weeks ago and has started to run off at the pace of about $20 billion a month. After the somewhat disappointing employment report, we think it's a close call whether the FOMC will decide to let this continue for now or announce a decision to start reinvesting MBS principal repayments in Treasuries. From a direct market perspective, this decision probably won't end up being too important. A Fed decision to start buying $5 billion a week in short-end Treasuries probably wouldn't impact yields much, and if no change is made, a $5 billion a week reduction in the over $1 trillion in excess bank reserves seems unlikely to alter banks' behavior noticeably in the medium term. But the press reports that the economic data have been disappointing enough to shift the Fed's policy focus in this direction were enough to convince investors to extend a four-month-long trend of steadily pricing out the move towards an exit strategy that was probably coming closer to being implemented in early April before the European turmoil led to the recent bout of softer economic data. The January 2012 fed funds futures contract is now at 0.575% after an 8bp rally the past week and 28bp rally the past month and 155bp rally the past four months, leaving the market now only expecting one 25bp rate hike by the end of next year. If this outlook and only very gradual hikes beyond that priced into fed funds and eurodollar futures end up being right, then the intermediate part of the curve continued to look attractively valued even at the already record low yields coming into the week, so gains were extended a good bit further Friday. The past week's data weren't really bad overall. Payrolls results for July and revised June were significantly worse than expected, with private sector job growth in July a disappointing +71,000 on weaker results for temp-help jobs and leisure hiring, and overall job growth was additionally depressed by a plunge in state and local government jobs at the start of the new fiscal year in most states. State and local government payrolls are a key input into calculations of government spending in GDP. There was some positive offset in underlying details on hours and earnings, however, and the unemployment rate at least held steady. Meanwhile, both ISM surveys for July posted robust results and upside in auto sales and slightly positive results from chain store sales reports pointed to a solid July retail sales report.
On the week, Treasuries out to the 20-year area posted decent gains led by the 7-year, while yields at the long end rose modestly as shifting money out of bonds and into 5s and 7s remained a persistent theme that was added to by caution ahead of the upcoming week's long-end supply. The 2-year yield fell 4bp to 0.51%, 3-year 7bp to 0.76%, 5-year 5bp to 1.51%, 7-year 8bp to 2.20%, and 10-year 8bp to 2.82%, while the 30-year yield rose 2bp to 4.00%. The latest leg of the rally that started in April continued to be entirely in real rates while inflation expectations have risen, and TIPS saw a third week of outperformance. The 5-year TIPS yield fell 11bp to -0.01%, 10-year 10bp to 1.02%, and 30-year (which is seeing some early supply jitters ahead of the reopening later in the month) 1bp to 1.86%. Since the low for the year was hit on July 19, the 5-year/5-year forward breakeven inflation rate has risen about 15bp to near 2.2% - which is pretty much exactly what we'd predict the actual result is likely to be and is right in line with the Fed's long-term inflation goals (building in a bit of upside bias in CPI relative to the 1.9% long-term PCE inflation target). The MBS market continued to show big divergences across the coupon stack as investors tried to decide how much of a risk should be priced into super-premium higher-coupon issues of a policy change that will allow homeowners stuck in way above market rate mortgages to refinance. The severity of this issue was well illustrated by the July prepayment results. As mortgage rates plunged to record lows, prepay speeds in 6% and 6.5% MBS actually declined and 5.5% didn't rise much. As they started to become refinanceable on a rate basis, however, 4.5% MBS, which do not have the credit issues to a meaningful degree that are widely stopping refis in higher rate mortgages, prepay rates sharply accelerated - by 19% to 12.3% annualized for Fannie 4.5%s, by 51% to 14.2% annualized for Freddie 4.5%s, and by 18% to 8.4% for Ginnie 4.5%s (see Agency Prepay Commentary by Janaki Rao and Zofia Koscielniak, August 6, 2010, for details). There was a bounce in higher-coupon MBS early in the week after the prior week's poor showing, but bad relative performance resumed late in the week, which left Fannie 5.5% and 6% issues lagging Treasuries by about a quarter-point for the week. But 4% issues rallied in line with Treasuries, leaving current coupon yields at record lows below 3.5% at Friday's close. This puts the big universe of 4.5% MBS on the cusp of a big pick-up in refis if the unusually wide spread of 30-year rates over MBS yields starts to narrow and 30-year rates start being offered at 4.25% instead of the 4.5% they've been stuck at for a while. These issues make up half of the Fed's $1.1 trillion MBS portfolio, so the great recent performance by lower-coupon mortgages has made FOMC consideration of what to do about mortgage prepays in the Fed's portfolio a more pressing issue in the past few weeks.
After posting big gains on Monday and putting pressure on rates markets, stocks didn't do much the rest of the week and didn't have much impact on Treasury yields after Monday. The S&P 500 gained 1.8% on the week after jumping 2.2% Monday and then not moving much. Energy and healthcare outperformed and consumer staples and financials lagged with only fractional advances. Press coverage of Thursday's chain store sales results was apparently a lot more negative than the reality, since consumer discretionary stocks outperformed Thursday and rallied in line with the market for the week. Our translation of the chain store sales numbers was that they pointed to small sequential gains in general merchandise and clothing store sales in the upcoming retail sales report. Credit markets also rallied strongly Monday, but the subsequent pullback off the highs was more pronounced. For the week, this resulted in the investment grade CDX index ending unchanged at 104bp and the high yield index tightening only 15bp to 544bp.
Non-farm payrolls fell a larger-than-expected 131,000 in July, with census jobs down 143,000, other government plummeting 59,000 on a very weak result for state and local jobs, and private payrolls up a disappointing 71,000, with notably worse results in temp jobs (-6,000) and leisure (+6,000). There was also a large downward revisions to June (-221,000 versus -125,000) job growth. The dip in temp jobs in July followed a record 30% annualized increase over the prior nine months. The plunge in state and local employment in July at the start of the new fiscal year for most states pointed to weak S&L spending growth in 3Q in the GDP report. We took our estimate down a half-point to +0.5%, with construction spending expected to be up another 10% on top of the 12% gain in 2Q as the lagged impact of the 2009 fiscal stimulus bill continues to be felt, but S&L spending ex construction on pace for a 1% decline (which is actually pretty large for this low-volatility component of GDP). Note though that there is huge seasonality in local government jobs in July because of the end of the school year - seasonally adjusted local government education payrolls fell 27,000 while NSA fell 1,282,000 - so it's possible that the weakness in July was exaggerated by seasonal adjustment issues and there will be some rebound next month. Aside from the weak payroll numbers, however, other key details of the report were uniformly positive. The unemployment rate held steady at 9.5%, down 0.2pp since census workers started being laid off (and apparently leaving the labor force). The average workweek rose a tenth to 34.2, and average hourly earnings growth accelerated to +0.2%, resulting in aggregate weekly payrolls, a proxy for total wage income, surging 0.6%. And hours in the factory sector showed good upside, pointing to a strong industrial production report for July.
Other data for July were positive overall, with the manufacturing ISM falling slightly but to a still-quite-strong level (though underlying component details were not as robust), the non-manufacturing ISM posting a good gain, and upside in auto sales and somewhat sluggish but still modestly positive chain store sales results pointing to good gain in retail sales.
The composite manufacturing ISM index dipped only 0.7 points in July to hold at a robust 55.5, a level that historically has been associated with 4.5% growth in the overall economy, though clearly this recovery so far has been much more manufacturing-led than normal. Underlying details were less positive, however. The expansion was less broadly based, with 10 of 18 sectors reporting growth in July compared to 11 in June and a high of 17 in April and March. Among the components, the key orders (53.5 versus 58.5) and production (57.0 versus 61.4) showed notably slower growth, through the employment index rose nearly a point to 58.6, one of the highest readings in the past 30 years. Meanwhile, the composite non-manufacturing ISM index rose a half point in July to 54.3. Underlying details in this report were also solid. The business activity index (57.4 versus 58.1) pulled back a bit but held at a high level, while the orders gauge (56.7 versus 54.4) improved and the employment index (50.9 versus 49.7) reached its highest level since December 2007.
Incoming data releases looking back to 2Q pointed to a downward revision to the initially reported +2.4% growth rate, but with almost all of the downside so far in inventories, which has positive offsetting implications for 3Q. Construction spending ticked up 0.1% in June but there was a significant downward revision to May (-1.0% versus -0.2%). Of particular note, business construction spending fell 0.5% in June and there were downward revisions to May and April. These softer-than-expected results suggested that the 5% gain initially reported for business investment in structures in 2Q will likely be revised down to -1%. The factory orders report, however, showed slightly better results for core capital goods shipments than initially reported in the durable goods release for both June (+0.5% versus +0.2%) and May (+1.6% versus +1.5%), pointing to even stronger 2Q equipment investment. We see 2Q equipment and software investment being revised up to +23% from +22%, which would offset much of the likely downside in structures and result in overall business investment in being adjusted down to +16% from +17%. This would lower the initially reported 2.4% 2Q GDP growth rate by a tenth. There were much bigger GDP implications from a 1.7% plunge in June non-durable goods inventories, far lower than the +0.5% BEA assumed. This suggests that the initially reported +1.1pp contribution to 2Q growth from inventories could be cut in half. We see the strong 4.1% gain initially reported for 2Q final domestic demand growth (GDP excluding inventories and trade) being moved down marginally to +4.0% on the slightly lower expected growth in investment, and we see 3Q on pace for a moderation to near +2.75%. And we forecast that net exports will add a point to 3Q GDP growth after the near record 2.8pp drag in 2Q. Initially, we were expecting inventories to be about neutral in 3Q, leaving overall GDP growth a bit above 3.25%, but the non-durable inventories plunge in June suggested that the inventory contribution in 2Q could be revised down a half-point - but with the possibility of offsetting upside of this magnitude to 3Q growth.
The economic calendar is quite busy again in the coming week, with focus on the FOMC meeting Tuesday, the refunding auctions Tuesday to Thursday - $34 billion 3-year Tuesday, down $1 billion from last month and $6 billion from the peak, $24 billion 10-year Wednesday, and $16 billion 30-year Thursday - and a number of key data releases, with focus on retail sales and CPI Friday. As was highlighted by Wall Street Journal reporter Jon Hilsenrath in his FOMC preview articles, an important issue the Fed will likely need to spend time thinking about Tuesday is whether it remains comfortable not reinvesting its MBS principal repayments or whether cautiousness about the economic outlook has risen enough that it seems more prudent to prevent this passive scaling back of quantitative easing. The Fed's mortgage holdings peaked at $1.129 trillion on July 14 and have already fallen $11 billion in the three weeks since, which along with an increase in the Treasury Department's cash balance at the Fed has resulted in bank reserves declining $31 billion. At currently expected mortgage prepay rates, our desk expects that the Fed's MBS portfolio will run off at the rate of about 2% a month, or about $20 billion. Excess reserves in the banking system remain enormous at over $1 trillion, so it seems unlikely that a decline of $20 billion or so a month would have any material near-term impact. But with the disappointing recent economic data and increased Fed cautiousness about the economic outlook, the FOMC may not consider it the right time to allow even this small amount of tightening to passively occur. After Friday's weaker-than-expected payroll numbers, we think it is a close call as to whether the FOMC will announce after Tuesday's meeting that going forward MBS prepays will start to be reinvested. If so, we expect that the money will be used to buy short-dated Treasury coupon securities, which would allow the Fed's huge ownership share of the MBS market to still gradually decline, while reducing complications in moving back to an exit strategy when the time comes.
Key data releases due out this week include productivity Tuesday, trade and the Treasury budget Wednesday, and retail sales and CPI Friday:
* We expect 2Q productivity growth to slow to +0.6% and unit labor costs to rise +0.4%. Productivity appears to have moderated in 2Q, with output rising 2.6% and hours expected to be up about 2%. Also, while productivity should be revised higher in 1Q, there will be net downward adjustments to prior quarters, reflecting the slower pace of GDP growth seen in the latest round of annual revisions. Meanwhile, unit labor costs appear to have posted a fractional rise in the latest quarter, but remain extremely well contained from a longer-term standpoint. Indeed, the impressive run of corporate profitability in recent quarters can be directly traced to the performance of unit labor costs.
* We look for the trade balance to widen $3 billion in June to $45.5 billion, with exports flat and imports rising 1.6%. On the export side, moderate upside in capital goods led by aircraft along with a good gain in autos should be offset by softness in industrial materials, in line with the drop in non-durable manufacturing goods shipments. On the import side, EIA data point to a decline in petroleum product import volumes in June and prices were little changed, but there was a surge in volumes in June reported by the EIA that didn't show up in the trade report in either April or May but we are assuming will show up in June based on the GDP report and BEA's assumptions for June imports. Port data also point to another good increase in non-energy goods imports. Note that our deficit forecast is in line with what the BEA assumed in the GDP report.
* The federal government should report a $165 billion budget deficit in July, about $15 billion less than in the year-ago period mainly because of lower TARP outlays. Also, revenues were a bit higher, reflecting a further pick-up in corporate taxes and another jump in Federal Reserve remittances. With only a few months to go in F2010, we see the budget deficit tracking at about $1.30 trillion - a little more than $100 billion below the prior fiscal year, but still representing a whopping 9% of GDP.
* We look for a 0.8% rise in overall July retail sales and a 0.5% gain ex autos. A solid rise in the auto dealer category, along with a price-related gain at gas stations, are the main contributors to the expected upside in July retail sales. Meanwhile, chain store reports were mixed and point to modest increases in the apparel and general merchandise sectors. So the key retail control gauge is expected to tick up 0.4% - far from an impressive advance but noticeably better than seen in recent months.
* We expect the consumer price index to rise 0.3% overall in July and 0.1% ex food and energy. Gasoline prices held reasonably steady during the past month, in contrast to the seasonal decline that is generally evident around this time of the year. So, after seasonal adjustment, the energy category is expected to show a significant gain. Meanwhile, we expect the core to just barely round down to +0.1%, following on the heels of the 0.16% uptick seen in June, as the shelter category should show continued signs of a meaningful turnaround. Indeed, there are increasingly widespread signs of a gradual tightening in rental market conditions - most notably, stock prices of apartment REITs have risen about 30% year to date. Finally, on a year-on-year basis, the core is expected to hold at +0.9% in July, but should begin to trend higher in coming months, reflecting the upside in shelter and easier comparisons.
While market-implied country risk for Argentina remains elevated, we are turning still more constructive on the near-term macro outlook. Whether we follow the official or alternative measures of economic growth, Argentina's economy is in the midst of a scorching recovery. Indeed, we suspect that Argentina is set to post one of the highest rates of growth in Latin America this year. In turn, the stronger growth outlook implies stronger fiscal results and more manageable financing over the next 15 months. With tax collection largely tied to growth, stronger activity should boost fiscal revenues in the quarters ahead. And while the market-implied risk premium on Argentine debt has fallen in recent months, it remains elevated - implying a non-trivial probability of default even in the near-term - in stark contrast to the comfortable state of public finances.
Stronger Growth
The pace of Argentina's growth expansion has surprised on the upside over the past few months. Sequentially, Argentina's economic expansion has gained steam near the turn of last year: according to our estimates, activity expanded at an annualized rate of 9.6% in the three months through December. Since then the pace has not let up - we estimate that GDP expanded at an 11.4% annualized rate in the three months through June and similarly strong readings in the interim. Meanwhile, official statistics record even stronger growth - the monthly economic activity indicator shows that the economy expanded at a 17.9% annualized rate in the three months through May. The strong pace of growth means that in annual terms GDP grew 10.2% in the three months through May according to official data and 8.0% in three months through June according to our estimates.
Stronger growth is driven largely by three factors: a recovery in soft commodity volumes, strong demand from Brazil and strong domestic consumption. While we had anticipated the strength of the agricultural volume recovery and Brazilian demand, the robust rebound in domestic consumption has come as a surprise.
Recovery in both agricultural production and industrial exports to Brazil is an important driver of economic expansion underway in Argentina. The agricultural complex in Argentina, particularly soft commodity production, was severely hit last year by the worst drought in nearly 50 years. The combined production volume of soybeans, corn, wheat and sunflower - the main crops produced in Argentina - was down 38.5%Y. With weather conditions turning favorable, estimates from the Ministry of Agriculture and the USDA suggest that the soft commodity complex should rebound 54.6% this year. This recovery in production volume supports robust economic expansion this year. In addition to the recovery in soft commodities, industry has benefitted from strong Brazilian demand. While the dollar value of total exports grew 18.0%Y in the first six months of the year, the dollar value of exports to Brazil expanded 34.6%Y in the same period. These drivers of economic expansion are broadly consistent with the outlook for Argentina that we outlined back in March (see "Argentina: V-Shaped Recovery" in This Week in Latin America, March 22, 2010).
The recovery in household consumption is the engine behind the surprising strength of the economic expansion this year. While we had expected the economic recovery in Argentina to be driven largely by external factors - soft commodity and industrial exports - the data suggest that private consumption has been an additional, powerful driver fueling economic recovery. Given that private consumption accounts for roughly two-thirds of real GDP in Argentina, a consumer boom has significant implications for overall activity. Our original view centered on inflation eroding real wages and thus limiting purchasing power already this year. However, organized labor, despite being weakened during the severe downturn last year, appears to have regained strength and succeeded in negotiating salary increases in the 25-30% range for the year. Thus, with our estimates of inflation running near 20% in June and with median 12-month-ahead expectations at 25% during May-July, real wages in Argentina should continue to outstrip inflation and provide support to expanding household consumption. Indeed, we project that household consumption will be key to strong growth this year and next.
Forecast Changes
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