Although the Fed's MBS 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. Until now, the settlement of these transactions has just about offset the impact of prepayments, and the Fed's overall MBS holdings have thus 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 would have started to become more apparent shortly, absent any new action.
The decision to buy "longer-term" Treasuries represents a significant surprise. We (and others) had thought that the Fed would focus any buying related to a change in its MBS reinvestment policy on short-dated Treasuries. That's because the program was being advertised by the Fed as a "symbolic" change that did not have much economic significance. Also, we thought that resistance to the reinvestment change by the hawks on the FOMC would, at best, lead to a compromise in which any buying would be focused in the front end in order to alleviate concerns about an eventual exit strategy. Instead, the Fed appears to want the program to have somewhat greater economic significance by spreading out its buying across a broader maturity spectrum.
In fact, it's important to recognize that by using terms like "longer-term" and by following up with an indication that the purchases will be concentrated in the 2- to 10-year sector, the Fed is using the very same language that was used to announce the $300 billion Treasury purchase program in March 2009. In that case, the average maturity of the purchases wound up being about eight years. Last Wednesday, the Fed's open market desk released its schedule of operations for the next month, confirming that the Fed will buy across the curve - including TIPS. Keep in mind that there are large sectors of the Treasury market where the Fed is already bumping up against the 35% limit on its ownership share. So, the open market manager will have to pick and choose carefully among outstanding issues. The Fed's goal will be to hold its SOMA (System Open Market Account) portfolio near the current level of $2.054 trillion.
Market implications. This change in the Fed's reinvestment policy is more than a symbolic shift because it both avoids a passive shrinkage of the Fed's balance sheet and tees up the markets for a more aggressive asset purchase program at some point down the road if - contrary to our expectations - economic conditions were to deteriorate in a meaningful way. Also, the Fed's buying will take duration out of the market that the shrinking balance sheet would otherwise have added; this should bring down retail mortgage rates. However, mortgage prepay speeds are slower than would be expected in the current rate environment, so our trading desk estimates that principal repayments will lead to about a 1.1% per month decline in the Fed's MBS portfolio over the next few months. On a base of $1.12 trillion of holdings, this amounts to about $12 billion per month. Add in another $2 billion for agency reinvestments and this totals $14 billion per month (note that this amount could increase in the not-too-distant future if prepay speeds were to rise, and also that the first round of buying will be somewhat larger - $18 billion - because it includes an extra payment date).
How do the Fed purchases stack up against new Treasury supply? Our budget deficit forecast is $1.3 trillion for FY2010 - and a bit less than that for next year. So, in rough terms, these Fed purchases can be scaled against about $100 billion per month of net new Treasury issuance. Also, the new coupon issuance has an average maturity of about seven years, which is reasonably close to the expected average maturity of the Fed's purchases.
Is the Fed running out of ammunition? Since the FOMC announcement yesterday afternoon, we've received a number of enquiries with a common theme. They all go something like the following: "What is the Fed trying to accomplish? Treasury yields are already so low that a modest amount of Fed buying is not going to do much. In fact, they are running out of bullets. The three examples of additional monetary stimulus that Bernanke offered in his Humphrey-Hawkins testimony are next to meaningless. Changing the wording of the "extended period" reference isn't going to accomplish anything; eliminating interest-on-reserves (IOR) does more harm than good; and expanding the balance sheet will just create more excess reserves. Nothing the Fed can do will create jobs, stop homeowners from defaulting, or cause banks to start lending." (And this is a relatively restrained synopsis of my incoming emails!)
As a starting point to understanding the Fed's approach to preventing deflation, one might want to go back and review the seminal speech that Bernanke delivered on this topic in November 2002. The key excerpt from the speech is shown in italics below, but the approach can be simplified as follows:
1) Take the policy rate to zero (or as close as is practical).
2) Reduce short-term Treasury yields by either promising to keep the policy rate low or by setting a cap on the yield of these securities.
3) Reduce longer-term Treasury yields by setting a cap on the yield of these securities.
4) Reduce MBS yields by setting a cap on the yield of these securities.
5) Lend directly to the private sector - via the banking system - by accepting a much broader range of collateral at the discount window than at present.
6) If all else fails, rev up the helicopters.
To be sure, the Fed has studied this issue in greater detail since Bernanke delivered the speech in 2002, and it may have identified a better mouse trap. But it's still useful to understand the model that the current Fed Chairman outlined almost a decade ago when he was a mere governor and could speak more freely about such topics. Most importantly, it's clear that the monetary transmission mechanism in his model works through rates - not the size of the balance sheet or the quantity of excess reserves (this is one reason why the "QE2" terminology is a bit of a misnomer). The creation of excess reserves is merely a by-product of asset purchases or direct lending. In this model, it is lower rates that are supposed to help spur a pick-up in aggregate demand (of course, I can't resist pointing out that a streamlined refi initiative would provide powerful reinforcement for this objective). In the end, I'm not sure that a review of Bernanke's 2002 model will alleviate concerns that the Fed is running out of ammunition, but at least one might now have a better sense of the bullets that are still in the clip.
Here is the key excerpt from Bernanke's 2002 speech:
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure - that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time - if it were credible - would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
Lower rates over the maturity spectrum of public and private securities should strengthen aggregate demand in the usual ways and thus help to end deflation. Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).
Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951...
To repeat, I suspect that operating on rates on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios. If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.
Finally, here is the link to the full Bernanke speech: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm
Big gains at the intermediate and longer ends and small front-end losses led to a substantial flattening of the Treasury yield curve over the past week as a continued run of sluggish economic data pointed to slower growth in 2Q and 3Q, and the FOMC's decision to prevent a passive scaling back of quantitative easing by directing the New York Fed to start reinvesting MBS and agency maturities into Treasuries ended up negatively impacting sentiment. The Fed's shift itself was not a surprise, but the decision to buy Treasuries across the curve made the move somewhat more substantive than symbolic relative to our thinking that the buying would be concentrated in shorter-dated Treasuries. After a mildly positive initial reaction, however, many market participants apparently decided that the Fed was to some extent validating rising (excessively so, in our view) pessimism about the economic outlook but without actually doing much about it aside from stabilizing the amount of excess reserves in the banking system at $1 trillion by keeping the size of its retained portfolio at $2 trillion while extending the duration its holdings a bit. In addition to a much better relative performance by the long end of the Treasury curve after the FOMC decision following a poor run over the prior few months that had left 5s-30s and 10s-30s at all-time record highs at Tuesday's close, the more sour post-FOMC sentiment was also seen in a sizeable move lower in inflation expectations in the TIPS market after several weeks of modest upside, sizeable pullbacks in equity and credit markets, some softness in commodity prices and a safe-haven rally in the dollar. Most of the week's net swings took place in just one rough trading session on Wednesday, however, so the unhappiness of some investors with the Fed's approach may have only a short-term impact for now. After Wednesday, rates markets dealt with some temporarily disorderly losses in the MBS market that was partly related to the Fed's portfolio shift, but risk markets stabilized Thursday and Friday. A continued soft run of economic data also fueled the market pessimism. A much bigger-than-expected widening in the June trade gap and another disappointing retail sales report for July pointed to a bigger downward revision to 2Q GDP growth and a weaker initial trajectory for 3Q. Coming into the week, we were expecting 2Q GDP growth to be revised down to +1.7% and saw 3Q tracking at +3.8%. Incorporating the trade and retail figures, we now see 2Q being revised down to +1.3% and 3Q running at +3.4%, so the mid-year growth pace looks about a half-point slower. It's important to note, however, that as miserable as a +1.3% 2Q GDP result would be, at this point all of the revision we expect relative to the initial +2.4% outcome is expected to come in trade and inventories. Underlying final domestic demand grew over 4% in 2Q, and in the process sucked in a huge amount of imports instead of immediately flowing through into similar upside in domestic production. We don't expect that pace to be sustained, but we do think that a pace of underlying demand growth near 2.75% can be sustained in the second half, which, along with a positive shift in net exports and continued inventory restocking, can support overall GDP growth near +3.25% in coming quarters.
With the long and intermediate parts of the curve posting good gains, led by the 10-year over the past week and short end selling off slightly, there was a decent curve-flattening move. The 2-year yield rose 3bp to 0.54% and old 3-year 2bp to 0.77%, while the 5-year yield fell 4bp to 1.46%, 7-year 14bp to 2.06%, old 10-year 16bp to 2.66%, and old 30-year 13bp to 2.87%. After several weeks of steady outperformance since lows in inflation breakevens for the year were hit in July, TIPS badly underperformed after the FOMC meeting, sending inflation expectations back down to the July lows. The 5-year TIPS yield rose 7bp to 0.06%, 10-year fell 4bp to 0.98% and 30-year fell 7bp to 2.07%. As a result, the benchmark 10-year inflation breakeven, which had risen from a low of 1.69% on July 19 to 1.85% at Tuesday's close, was back down at 1.70% at Friday's close after an initial move higher Tuesday afternoon after the FOMC statement was released was sharply reversed in subsequent days. This tracked a pullback in commodity prices, with September oil down 6% on the week and December wheat down 3% on the week and 10% since the August 5 high, and a rally in the dollar. And for some reason TIPS initially responded negatively to the CPI report, which showed a bit of upside. The consumer price index rose 0.3% in July, lifting the year-on-year pace slightly to +1.2%, boosted by a 2.6% jump in seasonally adjusted energy prices as gasoline held steady in a month when it normally declines. The core CPI gained 0.1% (keeping the annual pace at +0.9%) on a gradual turn higher in shelter costs after this category accounted for all of the deceleration in core CPI over the past several years. After an unprecedented run of declines in late 2009 and early 2010, the key owners' equivalent rent category rose marginally in May and 0.1% in June and July, tracking with a lag a tightening in rental conditions across the country. Rents turned up earlier and have risen for five months now, and hotel prices have shown a run of good increases since February.
After a big initial curve-flattening rally Wednesday as the market sharply reversed the initial reaction to the FOMC statement to price in a more negative outlook, the rates market focus mostly turned to some dislocations in the mortgage market. Higher-coupon mortgages have been underperforming for two-and-a-half weeks now since investors first started to consider more closely what could happen to the sharply elevated prices on these issues if policy changes were implemented to allow more homeowners to refinance who are now stuck in high-rate mortgages because of tighter credit standards and lower home equity. Lower-coupon MBS had continued to outperform the strong run in Treasuries, however, taking current coupon yields to fresh all-time lows below 3.4% at Wednesday's close. This persistent strength finally seems to be starting to drive some downward pressure on 30-year mortgage rates after they held just above 4.5% on average through July as MBS yields were falling, resulting in the current unusually wide spreads between mortgage yields and mortgage rates. Freddie Mac's national survey showed average 30-year rates at another record low of 4.44% this week, so there seems to be some movement. Given where MBS yields are, without the current capacity constraints and reduced competition in the shrunken mortgage origination industry, rates would probably already be down near 4.25%, which would probably be leading to sharply elevated rates of prepayments on 4.5% MBS (based on underlying mortgage rates around 5.25%). These issues broadly have strong credit quality and substantial positive equity since the underlying mortgages were extended after the financial crisis hit, so when rates become attractive enough, there shouldn't be any of the issues restraining refis in the higher coupons The Fed's portfolio shift, at least in a symbolic sense selling MBS for Treasuries, and rising concerns about market positioning if the Fed's huge holdings of 4.5% MBS start to refi at an elevated pace into new lower-coupon issues that the market will have to absorb, coming on top of the ongoing pressure on higher-coupon issues as investors price in some risk of a policy shift for high-rate mortgages led to the worst day for the MBS market in a year-and-a-half on Thursday, with large and somewhat disorderly losses across low and high-coupon issues. This had big knock-on impacts on volatility (which moved up significantly after hitting two-and-a-half-year lows Wednesday), swap spreads and Treasuries. Thursday's MBS rout created a lot of investor nervousness, naturally, but things settled down quickly, at least for now, on Friday. On the week, 4.5% MBS lagged Treasuries by about a third of a point, but after a good recovery Friday still posted a modest rally in absolute terms, leaving current-coupon MBS yields near 3.4%, just above the record lows hit Wednesday. Our desk was noting a good pick-up in mortgage origination activity Friday and expects that the weekly mortgage applications survey could start to show a more substantial pick-up in refinancing activity in the coming weeks. On top of this expected pick-up in refis, investors will be watching Tuesday's Treasury Department conference discussing the future of housing finance and the GSEs for any new policy initiatives that could impact refinancing speeds.
Stocks took a big hit on the week and credit came under more modest pressure, supporting the Treasury market gains. Almost all of the weakness in stocks was in a 3% plunge Wednesday, however. For a week-and-a-half prior to that, the S&P 500 hardly moved on a day-to-day basis, and then Thursday and Friday it was back to barely moving again, just at a lower level. For the week as a whole, the S&P 500 fell 3.8%. The post-FOMC worsening in growth expectations among many investors was reflected in bigger losses in cyclical areas, with industrials, financials and tech underperforming. Credit also took a significant hit Wednesday, but there was a bit of upside early in the week and small gains late in the week, so the net losses weren't too big. The investment grade CDX index widened 4bp to 108bp and the high yield index about 30bp to 575bp. While the effectively zero credit risk agency MBS market saw some substantial volatility and a particularly rough day on Wednesday as investors worried about the pace of future refinancings and the implications of the Fed's reinvestment policy shift, the weaker credit areas of the mortgage market put in a good showing on the week, with the AAA subprime ABX index up 1% and AA up 4%.. Gains were supported by the FHA's announcement on August 6 that its "FHA Short Refinance" program that was initially discussed in March would launch on September 7. The program will "offer certain ‘underwater' non-FHA borrowers who are current on their existing mortgage and whose lenders agree to write off at least ten percent of the unpaid principal balance of the first mortgage, the opportunity to qualify for a new FHA-insured mortgage". To qualify, the homeowners must be underwater on their mortgage, which cannot already be an FHA mortgage, current on their existing mortgage payments, and qualify for a new mortgage under standard FHA underwriting requirements. Meanwhile, the lender has to agree to write the principal on the mortgage down by at least 10% and lower the loan-to-value ratio to no greater than 115%. Our SPG research team was initially quite positive on the possibilities for this approach when it was announced in March, but it thinks that under the current structure the incentives for lenders and borrowers to participate may not be attractive enough for it to gain much traction.
Economic data released over the past week continued the recent sluggish trend, with worse-than-expected results in the international trade, retail sales and retail inventories pointing to slower growth in 2Q and 3Q. Retail sales gained 0.4% in July, but all of the upside was in autos (+1.6%) and gas stations (+2.3%). The key retail control grouping (sales ex autos, gas and building materials) fell 0.1%, extending a soft run since March. The most notable contributor to the recent weakness has been grocery store sales (-0.3%), which have fallen for five straight months even as food prices have shown small upside. Worse results for mall type categories - clothing (-0.7%), general merchandise (-0.2%) and sports, books and music (-0.1%) - than seemed to be suggested by the monthly chain store results also weighed on July results. And the most directly housing related categories - building materials (-0.3%), furniture (-0.3%) and electronics and appliances (-0.1%) - were soft again after some upside in the spring when ‘cash for appliances' incentives provided a boost. We were assuming a 0.4% rise in retail control in July, so the 0.1% decline was significantly worse than expected, and there was only a minor offset from a small upward revision to June (+0.3% versus +0.2%). Incorporating this result, we lowered our 3Q consumption estimate to +2.0% from +2.3% after the sluggish 1.6% rise in 2Q (which the June retail control revision wasn't large enough to alter).
Also negative for the growth outlook was a much-bigger-than-expected $7 billion widening in the trade deficit in June to $50 billion, high since October 2008, on a 1.3% drop in exports and 3.0% surge in imports. The somewhat good news in the worse-than-expected result for exports was that it was largely in a steep decline in capital goods (-3.8%), indicating that more of June's gain in domestic capital goods shipments went to domestic investment instead of overseas than previously thought. Industrial materials exports (-3.1%) were also down sharply and mostly as a result of lower volumes instead of prices, with drops across a range of energy and metals items. The jump in imports was led by a huge gain in consumer goods (+8%), and autos (+7%) also surged as automakers prepared for an unusually active July for the industry that should be reflected in a strong industrial production report on Tuesday. Capital goods (+1.2%) posted a decent gain, adding to the positive outlook for investment. BEA assumed a large widening in the June trade gap in preparing the advance GDP estimate, but this result still ended up being much more negative than expected. As a result, we look for the already enormous 2.8pp net exports subtraction from 2Q GDP growth to be revised down a half-point more to a near record -3.2pp. And the much-worse-than-expected June starting point pointed to less room for a quick reversal of this huge drag in 3Q. Even assuming about half of the major June deterioration in the deficit is reduced in July, we cut our 3Q net exports contribution estimate to +0.5pp from +1.0pp.
Building in the June trade deficit miss and a smaller-than-expected gain in June ex auto retail inventories (0.0% versus BEA's +0.1%) on top of previously reported data that were worse than the assumptions in the advance GDP report, in particular non-durable goods manufacturing and wholesale inventories, we see 2Q GDP growth at this point being revised down to +1.3% from +2.4%. Underlying demand still looks like it will show a very solid gain, however. We don't expect any revision to the initially reported 4.1% jump in final domestic demand - GDP excluding trade and inventories, so growth in consumption, business investment, residential investment, and government spending - a high since 1Q06. Instead, we see the full percentage point expected downward adjustment coming from a 0.4pp cut to the net export contribution to -3.2pp and a 0.6pp cut to the inventory contribution to +0.5pp. It is also important to note that the big drag from trade reflected the strength in domestic demand, so as arithmetically negative as it was for GDP growth, it did suggest economic weakness. We look for 2Q import growth to be revised up to +31% from +29%. Looking to 3Q, the expected downward revision to 2Q inventories initially suggested a half-point or so potential upside to our initial GDP forecast of +3.3% (which assumed no contribution from inventories), but with the quarter-point reduction in our consumption forecast to +2.0% and the worse outlook for net exports, we see 3Q at this point tracking at +3.4%. This builds in a 2.25% gain in final domestic demand after the 4% jump in 2Q, a half-point add from inventories, and a half-point add from net exports.
The economic calendar is busy early in the coming week but very light after Tuesday. Initial jobless claims this week will cover the survey period for the employment report and the initial regional manufacturing surveys will be released - Empire Monday and Philly Fed Thursday - so data focus will be partly on setting initial expectations for the August employment and ISM reports. The Fed's Treasury buying will start Tuesday in the 4-year to 6-year sector and there will be a second round of buying on Thursday in the 6-year to 10-year range. There are nine operations scheduled over the next month and total buying is projected by the Fed to be $18 billion. On the other side of the supply ledger, another big week of new supply after the past week's refunding auctions will be announced on Thursday, when the amounts of the following week's 30-year TIPS, 2-year, 5-year and 7-year auctions will be released. Supply has not been a problem at all for nominals recently, but the 30-year TIPS has been under some pressure recently on nervousness about the reopening on August 23. Key data releases due out include PPI, housing starts and IP Tuesday and leading indicators Thursday:
* We look for the headline producer price index to fall 0.2% in July, which would be a fourth consecutive monthly decline, as energy prices continued to slide. However, the dip is expected to be somewhat smaller than seen in June because food prices appear to have registered a modest rebound on higher quotes for dairy items (the recent spike in wheat prices is unlikely to show up until next month's report). Meanwhile, the core should be well behaved, with a modest rebound in the motor vehicle sector offsetting some further slippage in metals prices.
* We forecast a small rebound in housing starts in July to a 560,000 unit annual rate. Starts plummeted nearly 20% from April to June, reflecting the expiration of the homebuyer tax credit. We look for a modest 2% uptick in July, with the gain expected to be concentrated in the volatile multi-family sector. Rental market conditions have improved and vacancy rates are down, so we should start to see some improvement in apartment construction.
* We look for a 1.0% surge in July industrial production. The employment report pointed to a sharp jump in factory output for the month, with the auto sector likely to lead the way, as vehicle assemblies soared nearly 18% in seasonally adjusted terms. There should also be strong gains outside of motor vehicles. In particular, the metals, machinery, computers and textiles industries are all expected to post gains of better than 2%. One of the few negative contributions this month should come from a modest pullback in utility output, which had registered sharp gains in preceding months.
* The index of leading economic indicators is likely to post a fractional 0.1% increase in July after a small decline in June. This would leave it up 1% annualized in the past four months following a 12% surge in the year ended in March. The main positive in July should be the yield curve, with smaller adds from the manufacturing workweek, claims and supplier deliveries. Consumer confidence and the money supply are partially offsetting negatives.
It's difficult to know what to make of Brazil's economy today: on the one hand, we have been highlighting a series of data releases suggesting that the pace of economic activity stalled during 2Q, yet listed companies have so far produced strong earnings during the same quarter. And perhaps more importantly, guidance from many companies has suggested that 2H should be strong again. How can we resolve this apparent contradiction? I'd propose three thoughts:
Sequential Thinking: On the Margin
First, beware of different measurement methodologies: strong 2Q results do not contradict our view that the economy virtually stalled in 2Q. Most company results compare the current quarter to the same quarter a year ago. With that metric, even the macro data that we have been citing look strong. Industrial production, which was off sequentially -1% in June, was still up over 11% compared with a year ago. The month-on-month declines in industrial output in May (-0.2%) as well as April (-0.8%) all but vanished when those months' output is compared with the same month from a year ago: May industrial output was up 14.8% while April posted a 17.3% uptick when compared with the previous year. Year-over-year comparisons tell you a great deal about where you have come from, but not necessarily much about the pace at which or the direction in which you are moving now.
The same distinction applies for the central bank's GDP proxy. When May's GDP was first released, the authorities calculated it was flat to the previous month, but even that weak result still represented a 9.8% upturn compared with a year ago. The latest GDP proxy - for June - was released this past week and it showed the slump continued in June: real GDP in June posted a modest 0.2% uptick relatively to May, but June was still up 8.6% over the previous year. (With June's release, May GDP was revised downward to show a 0.1% decline sequentially, but still a robust 9.3% uptick over the previous year). Faced with such strong year-over-year results - both from the macro front and from company earnings - it is easy to argue with anyone suggesting a slowdown may be underway. And yet, on a sequential basis, two of the most important measurements of activity - industrial output and GDP - suggest that the economy stalled in 2Q.
Indeed, even the 2Q GDP report runs the risk of glossing over the recent weakness. It's not just corporate results that mask the recent stalling in the economy: if we map out monthly GDP levels as presented by the central bank in its relatively new monthly proxy, the IBC-Br, the level of output at the end of 2Q was virtually unchanged from that at the end of 1Q. But that doesn't mean that when the national statistical authorities at IBGE announce 2Q GDP, they will post a result close to zero. On a year-over-year basis, GDP should still be over 9%. Even on a quarter-over-quarter basis (annualized), GDP should be near 5%. But that is because quarterly GDP compares the average of output during 2Q to the average either of 2Q of the previous year or to 1Q. If activity was on a strong upswing (as it was in 1Q) and came to a halt in 2Q (as it apparently did), you will still see 2Q sequential GDP up (as we likely will).
For all the dueling metrics, we believe that a meaningful change took place in Brazil's economy during 2Q: production stalled. I still hear the view that in 2Q, the economy slowed the pace of growth, but that it was still growing. The monthly GDP data suggest to the contrary: activity between June and March was largely flat: zero real growth. I also hear talk that any ‘slowing' in the months ahead would simply represent a more difficult comparative from a year ago when activity began to accelerate. Our analysis is not about an easier or more difficult base of comparison: we are comparing each month to the immediately prior month.
Give Me Guidance
Second, what matters to most is not the quarter now passed, but what happens next: most companies have provided good guidance for 2H. That actually is our view as well: we expect Brazil's economy to grow near a 4% pace in 2H and into 2011. That pace may fall short of what the growth in Brazil's labor force demands, but it is a pace at which Brazil should be able to grow without undue pressures on inflation or its balance of payments.
While we are in the 4% camp - in part because we expect a subdued pace of growth in developed economies to translate into softer growth in the emerging world than we had seen between 2003 and 2008 - we admit we could be wrong. Brazil's economy could once again return to the 5-6% pace seen in recent years. The surprise could either be temporary and akin to what took place at the end of 2007 and 1H08 when developed economies began to slow but Brazil posted strong growth, or it could be longer-lasting (the promise of the ‘de-couplers'). However, our concern is that if growth returns to the 5-6% pace or faster, we are likely to see it challenged by more inflationary pressures and by significant imbalances in Brazil's external accounts. With all the focus on Brazil's strong growth earlier this year, little attention has been paid to the looming consequences of that on Brazil's broader external accounts.
What Just Happened?
Third, we still think it is important to revisit what caused the economy to stall during 2Q. The most popular view is that the economy's ‘pause' was either a consequence of tightening fiscal (and/or monetary) policy or a mid-cycle reduction in the pace of inventory build-up. As we discussed last month, we don't find the policy-induced explanation fully satisfying (see "Brazil: Slowdown - Comfort or Caution?", This Week in Latin America, July 26, 2010). While fiscal measures (the end of tax breaks for white goods at the beginning of the year and for automobiles in March) clearly played a role in bringing forward some consumption from the second to the first quarter, it is hard to argue that those measures fully accounted for the dramatic shift in growth from 11% annualized to close to zero. Especially since the fiscal impulse from both spending as well as revenues (and off-balance sheet activities of Brazil's development bank) at mid-year were at least as expansionary or more expansionary than at the beginning of the year. And yes, the central bank began hiking, but the first move was on April 29, while the weakening in production dates to February and March.
We suspect that inventory build-up contributed to part of the strength of the recovery in late 2009 and the first months of 2010. Indeed, national accounts data suggest that inventory accumulation played an important role in the 11.4% annualized jump in GDP during 1Q. We are a bit more hesitant to ascribe too much weight to national statistical measures of inventories. Inventories or stockbuilding is often used to resolve discrepancies between various measures of GDP. But there is both anecdotal evidence and word from Brazil's auto industry that suggest the rebuild in inventories has slowed and with it some of the robust production growth seen prior to 2Q.
What I still wonder is whether some of the slowdown in 2Q also came as companies looked abroad and saw a weakening global outlook and decided to slow the pace of production. If that was the case, it might explain the sharp contrast between the weak production data and most demand indicators that have remained strong. Employment growth is still strong in Brazil; real wages remain robust; credit to consumers remains healthy; and consumer confidence remains high. And it might explain the recent weakness seen not in ‘current conditions' readings by businesses as much as in ‘expected conditions' later in the year.
The link with the globe would also be consistent with Brazil's own track record: for all the talk that Brazil is largely a closed economy with a low export penetration, in recent decades Brazil's economy has moved with the global business cycle and with commodity prices. And it should serve as a reminder: if the globe slows, don't count on the Brazil domestic demand drivers rescuing you. A brief bout of production pause has little impact on employment or consumer confidence or credit, but if the hit to production were to return and last longer, the link to employment, consumer credit and confidence would not likely be far behind.
Bottom Line
After the overheating scare at the beginning of the year, I'd like to be the first one to welcome the pause in 2Q. A slower pace of growth should ease both inflation pressures and the scope of central bank tightening. Indeed, we suspect the central bank provides only a small hike on September 1 of 25bp or even goes on hold through the year's end. A slower pace of growth also reduces the risk of a greater imbalance than what has already formed in Brazil's external accounts.
But there is only one problem: it is not clear precisely what drove the economy's stalling out. While the conventional wisdom in Brazil seems to be forming that it was a much-needed response to policy tightening or an adjustment to inventories, I find neither explanation fully convincing. I suspect in part the 2Q performance was tied to concerns about global demand and that means Brazil watchers should not allow the attractive story of powerful domestic demand to leave them unprepared for the risks from a more pronounced global slowdown.
A Roller-Coaster Ride
It had been quite a rough ride for the Chinese property market so far this year. Discussions of an overheating property market seemed never-ending, while on the contrary the almost unanimous expectations of ever-rising property prices in the local market baffled many investors. The tide finally turned against the exuberance after the State Council announced a series of austerity measures in early April, aimed at reining in speculation in the property markets in cities where housing prices were deemed to be too high and rising too fast. Transaction volume has since plummeted, with prices expected to follow suit. Fear of an economic hard landing was brewing, and bearish sentiment was widespread.
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