Closer to sustainable, but still a sea change. We have long agreed with the basic deleveraging story. But there is surprisingly good news: American consumers have deleveraged their balance sheets and rebuilt saving faster than expected. While debt-to-income ratios and other measures of leverage are still elevated, household debt service is lower and saving higher than expected in relation to income. We estimate that the deleveraging timetable is nearly a year ahead of schedule. Looking ahead, the recent plunge in mortgage rates likely will push debt service still lower. Consequently, in our view, the headwind to consumer spending from deleveraging is now a smaller risk to the outlook, as consumers can spend more of their income.
Importantly, our story is optimistic only by comparison with the now-gloomy standard forecast. In our view, the key tail risk is still lodged in housing and home prices, as about one in four homeowners with a mortgage owes more than the house is worth. That is leading to a wave of ‘strategic defaults', in which borrowers who can otherwise afford to pay decide to walk away. Whether through foreclosure or strategic default, more mortgage chargeoffs are coming. We think that the sea change in consumer behavior wrought by recession will persist over the next several years, as dim prospects for gains in household wealth will maintain an elevated saving rate, limit the eventual recovery in household debt to below the pace of income, and cap real spending growth in a 2-2.5% range.
Grim standard metrics. Even our subdued optimism may seem surprising, because the standard gauges of household leverage - ratios of debt to income, debt to assets, or mortgage debt to owners' equity in real estate - paint a bleak picture of the average household balance sheet. While household debt in relation to disposable income has declined significantly from its peak of 123.6% in 3Q07, we estimate that it stood at 110.7% at the end of 2Q, or only back to 2004 levels. Moreover, mortgage debt in relation to tangible assets remained at 44% by 1Q10, while such debt in relation to owners' equity stood at 163%, both more than double historical norms. Those measures seem to imply that the deleveraging process - and episodic flirtation with retrenchment - could stretch out over several years.
But other measures depict a much more sustainable picture. The balance sheet snapshots just discussed are important, but in our view, they don't tell the whole story. Other, flow-driven measures capture some of the dynamics of balance sheet adjustment. One such measure of sustainability is the debt-service ratio - household payments of interest and principal on debt in relation to disposable income. By that metric, consumers are already at the threshold of sustainability, thanks in part to lower interest rates and a recovery in income. Debt service has declined from nearly 14% of disposable income in 3Q07 to an estimated 12.4% in 2Q10 - the lowest level in a decade. Indeed, with mortgage rates tumbling to all-time historical lows, the prospect of further declines in debt service from additional refinancing of mortgage debt imparts downside risks to our estimates of the debt-service burden.
The other encouraging metric is the personal saving rate. A year ago we thought saving might reach 6% of disposable income in 2011 from 2% in 2007. Revised national income accounts show a saving rate fully two percentage points higher than previously thought, one that had already moved up to 6.2% - a 17-year high - in 2Q10.
We'd be the first to acknowledge that a higher saving rate could manifest consumer hesitation - evincing the ‘paradox of thrift', in which too much saving weakens growth. However, careful modeling of consumer spending (although it does not explicitly account for declining debt service) confirms our intuition that consumers have adjusted to the loss of wealth more rapidly than we expected. Such analysis suggests that consumers adjust their outlays to a ‘target' level determined by wealth and after-tax income. When spending is below that target, outlays will adjust higher and vice versa. According to Macroeconomic Advisers, the deeper retrenchment that has already occurred and the higher income in these data suggest that the path of spending from here could be 25bp higher than previous estimates implied.
Courtesy of rapid reductions in debt service, upward revisions to dividend income (which tends to be saved), and deeper spending retrenchment in the past, these data now depict a consumer who has adjusted to the shock in wealth faster than previously thought. The combination of lower debt service, and thus more discretionary income, and a higher saving rate should limit downside risks to consumer spending.
Calibrating consumer deleveraging. How do we know whether consumers have delevered enough? Our research strategy a year ago consisted of two steps. First, we established what might be a sustainable level of consumer debt service in relation to income; our rough estimate is 11-12%, which might be associated with debt in relation to income of 80-100%. Then we used base, bull and bear scenarios to estimate how long it might take to approach those ratios under different circumstances. To link household debt and debt service to our economic scenarios, we estimated equations to describe the growth in mortgage and non-mortgage consumer debt, taking account of the factors that drive originations, repayments, refinancing and defaults. We built on our earlier work on credit losses and deleveraging at lenders to try to achieve internal consistency between the economic scenarios and losses and to incorporate the feedback from the economy to growth in debt.
Under any of the three scenarios, we thought that the 11-12% debt-service and 80-100% debt-to-income ratios might be attainable by 2011. At the time, that sounded extraordinarily rapid. But we pointed out that it would be anything but painless, as evidenced by key metrics in the deleveraging process, such as growth in debt, sustainable spending growth, and the personal saving rate.
The forecasts have held up well: Our baseline scenario was - and still is - consistent with an 8% contraction in mortgage and consumer credit between 2009 and 2011, and real annualized personal spending growth of 2-2.5%. Based on current data, it is also consistent with a personal saving rate of 6-6.5% in 2H10 and 5.3% by end-2011, reflecting our baseline assumption that taxes will go up for upper-income consumers. But we still believe that over a longer time period, consumers will boost their saving rate to 7-10%, reflecting limited growth in household assets and correspondingly still-high leverage ratios.
Additional implications of deleveraging. It's worth reemphasizing that lower debt service confers additional benefits on consumers not captured by traditional analysis:
• Lower debt service frees up discretionary spending power that does not show up in the personal saving rate, because that rate excludes the cash flow benefits of lower principal repayment.
• Lower debt service also makes consumers better able to service debt and more creditworthy. It's no coincidence that delinquencies on consumer loans peaked a year ago. That augurs a coming peak in loan charge-offs; meanwhile, the record pace of such write-downs is accelerating the clean-up of both lender and consumer balance sheets. Perhaps that's why the Fed's July Senior Loan Officer Survey revealed that the highest proportion of banks in 16 years reported increased willingness to make consumer installment loans.
• Finally, once achieved, a higher saving rate enables consumers to maintain spending, continue to pay down debt, and accumulate wealth the old-fashioned way.
The fallout from the shock dealt to market sentiment by the Fed's dovish policy shift at the August 10 FOMC meeting saw a major further extension in the past week of the powerful trends that began August 11 - huge gains at the long end of the Treasury market leading to a big flattening of the yield curve and resulting collapse in long-dated forward rates, a plunge in inflation expectations as TIPS continue to substantially underperform, and sizeable underperformance by the MBS market but still a strong enough showing in absolute terms to leave current coupon yields at near-record lows. Minneapolis Fed President Kocherlakota tried to calm investors Tuesday, saying that he believed the market's view that the FOMC's actions indicated that the "economic situation in the United States was worse than they, the investors, had imagined" was "unwarranted". This sentiment was quickly countered in the view of many investors by a speech and Wall Street Journal interview by St. Louis Fed President Bullard, whose comments indicated that he sees a significant risk of the US heading for a Japan-style deflationary morass. In the eight trading sessions since the FOMC meeting, the 30-year Treasury yield has fallen 37bp, 10s-30s and 5s-30s have fallen 20bp and 34bp from record highs, the 10-year/10-year forward swap rate has plummeted almost 60bp, the 10-year TIPS inflation breakeven has dropped 25bp and the 5-year/year forward breakeven by about the same 25bp, and Fannie 4% MBS have lagged Treasuries by 25 ticks. Other than a pause in a quiet Friday trading session, the bull-flattening and falling inflation expectations moves were only interrupted Tuesday in response to better economic data and a rally in equity and credit markets partly as a result of the better data. Industrial production rose sharply in July, led by a surge in auto assemblies but with good upside also seen in a range of key manufacturing sectors and in oil and gas drilling. Housing starts posted a small gain in July to halt the post-tax credit collapse, but the number of home completions and the number of homes under construction plunged to record lows, supporting eventual normalization in housing inventories and indicating limited further downside risk to new home construction, in our view. And the producer price index extended a recent run of underlying acceleration, with the core ex motor vehicles having accelerated to a +0.2% trend since March from a +0.1% pace over the prior year. These results were quickly forgotten, however, and the rising post-FOMC pessimism about the economic outlook and about the risks of deflation were given further impetus by weak results from the Philly Fed and jobless claims reports Thursday. Based on the weak underlying results from the Philly and Empire survey, our initial forecast is for a 3-point drop in the ISM to 52.5. We think that much of the upside in claims since mid-July, however, reflects the sharply accelerated pace of temporary census worker layoffs since mid-July rather than a severe sudden deterioration in the underlying job market. Still, it appears that the prior improving trend in the labor market has stopped for now, and we look for 40,000 gain in ex census payrolls in August (+50,000 private sector and a further 10,000 drop in state and local government jobs on top of the July plunge). While this would clearly be a sluggish gain in underlying payrolls, extending the recent disappointing trend to four months, taken at face value, the recent substantial upside in claims would point to a decline in underlying jobs this month, and that certainly seems to be the way the market is leaning at this point.
On the week, benchmark Treasury yields fell 1-21bp and 5s-30s plunged 20bp, as the long end surged and the 5-year and 7-year were pressured by the weakness in the mortgage market and received no apparent offsetting support from the initial $6 billion in Fed buying of Treasuries in off-the-run 5s and 7s. The 2-year yield fell 5bp to 0.49%, 3-year 4bp to 0.77%, 5-year 1bp to 1.45%, 7-year 1bp to 2.05%, 10-year 7bp to 2.61%, and 30-year 21bp to 3.66%. TIPS performed terribly in comparison, with the 5-year yield up 10bp 0.16%, 10-year yield up 4bp to 1.01%, and 30-year down 5bp to 1.74%. TIPS were unable to benefit from a bit of upside in underlying producer price inflation after ignoring the upside in core inflation the prior week. The PPI gained 0.2% in July (lifting the year-on-year rate to +4.2% from +2.8%), with energy prices (-0.9%) down for a fourth straight month and food (+0.7%) reversing part of a near-record decline in June. The core rose 0.3% (and almost rounded up to +0.4%), the largest rise of the year. Volatile motor vehicle prices added to the gain, but the core ex motor vehicles still gained 0.2%, a pace it has been running near each month since March after a trend near +0.1% over the prior year. Core consumer goods prices led the July upside, particularly a significant gain in drug prices. Nominal curve and TIPS performance since the FOMC meeting represents a complete about-face from the trends seen for several weeks going into meeting, when money was persistently moving out of the long end and into 5s and 7s to benefit from carry and rolldown while real rates were falling and inflation expectations drifting gradually a bit higher.
Mortgages had also been benefiting substantially for a good while from the low volatility, carry-focused environment before the FOMC meeting started the abrupt shift in expectations towards fears of a deflationary double-dip and away from a relatively benign prior outlook for a long period of low growth, low volatility, steady and moderate inflation, and no change in Fed policy. Aside from a good bounce Thursday, MBS underperformance through the week remained persistently bad after having turned broadly poor (higher-coupon issues had been hurting for a couple of weeks on fears of a policy shift to ease credit standards for refinancings) after the FOMC announced its portfolio readjustment. For the week, Fannie 4% MBS lagged Treasuries by nearly a half point even with a major bout of outperformance Thursday. Thursday's bounce came as the prior run of post-FOMC underperformance had been bad enough that lower-coupon issues were looking cheap, and after Friday's renewed weakness, our desk thinks that lower-coupon mortgages are cheap enough to own going forward. As bad as recent relative performance has been, with the general level of rates falling so much, MBS yields are still holding near all-time lows. The current coupon Fannie Mae MBS yield plunged all the way down to a new low of 3.31% Thursday on our mortgage strategists' calculations and even after Friday's reversal was only back up to near a still extremely low 3.4%. At this MBS yield level, 30-year mortgage rates should already be down to 4.25% or lower, and one of the bigger originators was seen offering rates of 4.125% late in the week. The biggest originators, however, in an industry that became very concentrated during the housing bust (the two biggest companies accounted for nearly half of 1Q activity) are still offering rates well above that, amid capacity constraints as refis have started to ramp up, leaving the national average rate at 4.42% this week according to Freddie Mac's national survey. If underlying MBS yields stay near these levels or move lower, mortgage rates being offered to consumers should continue to come down as originators ramp up their hiring. Already, the MBA's weekly mortgage refinancing index gained 17% the past week, accelerating a recent move higher to reach the highest level since May 2009. If 30-year rates head down to 4.25% or 4.125%, the big 4.5% MBS universe, which since it is based on mortgages extended in 2009-10 largely when credit standards were tight and home prices near their lows doesn't have the problems slowing refis in higher-coupon mortgages, should start to refinance at an accelerating rate. This should provide additional momentum to the already substantial progress by consumers in repairing their balance sheets (see US Economics: Deleveraging the American Consumer: Faster than Expected by Richard Berner, August 20, 2010).
With good gains on Tuesday, equity and credit markets managed to finish down only slightly for the week as a whole. The S&P 500 fell 0.7%, with energy, financial and healthcare stocks lagging. The consumer cyclical and materials sectors performed well enough when stocks were rallying in the first part of the week to hold onto small net gains, and tech stocks also rallied slightly on the week. The investment grade CDX index similarly only ended up 1bp wider for the week at 109bp, and the high yield index near 575bp was little changed (and comparatively quite stable on a day-to-day basis too). Some recent softening in the muni bond CDS market continued in the latest week as European peripheral government bond markets came under some pressure, and the fiscal mess in California, which still doesn't have a budget in place for the fiscal year that began July 1, was back in the headlines as Governor Schwarzenegger began widespread forced unpaid furloughs for state employees Friday and the state Controller John Chiang warned that he was running out of cash to pay vendors and might soon need to start issuing IOUs instead. For the week, the 5-year MCDX index widened about 5bp to near 225bp, high since mid-July and up from a low recent close of 197bp on August 3. On the positive side, as agency MBS have been coming under major relative pressure, the non-agency mortgage and CMBS markets have been doing much better recently, with the AAA ABX index gaining 2% this week and AAA, junior AAA, AA and A CMBX all 1%. There was some modest softening in the second half of the week in the broad risk market pullback, but the AAA ABX and CMBX had reached their best levels since May at Tuesday's close.
In a light week for economic news, the most notable release was industrial production, which surged 1.0% in July, for an 8.5% annualized gain since the June 2009 trough, as manufacturing continues to lead the recovery. With a major automaker not taking normal summer downtime in order to try to rebuild depleted inventories, motor vehicle assemblies surged 14% to a two-year high and overall motor vehicle and parts output gained 10%. This accounted for about half of a 1.1% gain in factory output, but manufacturing ex motor vehicles still rose a solid 0.6%, with good gains in machinery, fabricated metals, tech equipment, aircraft, petroleum refining and chemicals. After this robust July for manufacturing output, early indications pointed to a slowdown in August. On an ISM-comparable weighted average basis, the Empire State manufacturing survey fell 2 points in August to 50.3, a low since December, and the Philly Fed 4 points to 46.3, low since October. These results clearly warn of some weakening in national manufacturing growth, but it should be kept in mind these two regions also were a lot softer in July than the national ISM at 55.5 or the surge reported in industrial production, partly because they don't have material auto industry activity that provided a big boost to activity in other parts of the country. On a preliminary basis, we look for the national ISM to fall 3 points to 52.5 and will update our estimate as the rest of the major regional manufacturing surveys are released, including the Richmond survey on Tuesday and Kansas City on Thursday, both of which held up quite well in July, in contrast to the softer Empire and Philly readings.
The economic calendar is fairly light in the coming week, with reports on home sales, durable goods and revised GDP. The Richmond and KC survey and weekly claims report will also be in focus after the soft results the past week led to a pessimistic outlook for ISM and employment reports due out in a couple weeks. A lot of supply will have to be taken down, with $109 billion in coupon auctions from Monday to Thursday - $7 billion 30-year TIPS reopening Monday, $37 billion 2-year Tuesday, $36 billion 5-year Wednesday, and $29 billion 7-year Thursday. The Kansas City Fed's annual conference in Jackson Hole, Wyoming, starts Friday with a speech from Fed Chairman Bernanke on "The Economic Outlook and the Federal Reserves Policy Response", which will give the Fed chairman a chance to respond to the damage done to market expectations by the FOMC statement and subsequent Fed communications. Key data releases due out include existing home sales Tuesday, durable goods and new home sales Wednesday, and revised GDP Friday:
* We forecast a dip in July existing home sales to a 5.30 million unit annual rate. To qualify for the homebuyers' tax credit, contracts had to be signed by April 30, and closings originally had to take place by June 30. But closings were experiencing delays as the backlog of deals swelled. Before adjourning for the July 4 recess, Congress extended the closing deadline to September 30 (although contracts still had to have been in place by the original April 30 deadline). So, the impact of the tax credit on the existing home sales series will linger for another few months. But the NAR's pending home sales index registered a slight dip in June and thus we look for about a 1% decline in July resales.
* We look for a 3.5% jump in July durable goods orders. Company reports point to a sharp spike in the volatile aircraft category this month. Also, we should see some further upside in bookings of motor vehicles. So, we look for a significant rise in headline orders. However, the key core category - non-defense capital goods ex aircraft - is expected to register a 1.5% drop, continuing the bizarre pattern of declines in the first month of the calendar quarter (followed by bigger gains in the next two months) that has been evident for some time now.
* We expect new home sales to stabilize at a 330,000 unit annual rate in July. Sales of newly constructed residences plummeted 37% in May following expiration of the homebuyer tax credit and then registered a 24% rebound in June (note that unlike the existing home sales series, the new home sales data are based on contract signings). We look for the recovery to stall in July, reflecting the low level of homebuilder sentiment evident in the latest industry survey. On the brighter side, the number of homes available for sale is near historical lows and thus the downside for homebuilding appears to be quite limited even if sales remain soft in coming months.
* We look for more than a one percentage point downward adjustment to 2Q GDP growth to +1.3% from the originally reported reading of +2.4%. Almost all of the adjustment should be concentrated in two categories - inventories and net exports. Indeed, final domestic demand is expected to remain at the original reading of +4.1%, which was the best gain in over four years.
Following a short summer break, the CEEMEA Macro Monitor is back. We start with a focus piece on the region, providing an overview of the main changes in our views since January, including forecasts, the growth outlook, inflation, policy rates, the external picture and fiscal policy. For individual countries we include a brief summary of main data surprises seen over the past eight months that have affected our forecasts and forward-looking thoughts. We also provide our expectations for the rest of this year and into 2011, and draw attention to the key dates and risk events we think investors should consider.
In terms of the overall picture, a common theme for the region has been that the growth in 1Q and in some cases 2Q surprised positively, leading to an upgrade to our forecasts. With the exception of the Czech Republic and the UAE, which saw very minor downgrades in our growth forecasts, we now expect a stronger growth outlook for the region as a whole for both 2010 and 2011. That said, moderation in growth and in many cases deceleration in industrial production has already started to materialise (e.g., in Turkey, South Africa, Ukraine, the Czech Republic and Russia). This observation has been supported further by easing PMIs across our region.
On the monetary policy front, we have changed our rate calls significantly for some countries such as the Czech Republic, Turkey, Israel and the UAE on the back of extended weakness in external demand in most cases but also due to the monetary authority's approach to the currency. In the Czech Republic, we expect rates to remain unchanged until 2Q11, and a similar case for Turkey where we expect rates on hold in 2010, before likely rising in a measured fashion in 1Q11. In Israel, concerns surrounding currency appreciation remain despite rising prospects of inflation. We expect a much lower rate at year-end (2%) in comparison with our January view, implying only a 25bp hike. Nevertheless, we project continued normalisation of rates in 2011 in Israel. In the rest of the region, we maintain our view that the SARB will commence policy normalisation in 2Q11, which is earlier than consensus expects, and far more aggressive than market pricing of easier money by that stage. In the rest of Central Europe, we believe that central banks in Hungary and Poland will keep rates unchanged until year-end, but tightening in 2011 will commence sooner for the latter.
On the key dates and potential risk factors, we have the upcoming referendum on the constitutional amendment in Turkey on September 12 as the most immediate. Later on, in Hungary, we might witness some noise on fiscal matters, as well as future relations with the IMF, as October local elections arrive. Exactly the same might happen in Ukraine, with local elections coming up in October. Lastly, in Russia there will be parliamentary elections in December but we do not expect any noise.
Here are the details:
Turkey: Growth Still Intact with Loose Monetary Policy, but Moderation Has Already Begun
In comparison with last January, when we were projecting real GDP growth of 4%, we have raised our forecast by 1pp, mostly due to the faster-than-expected recovery in domestic demand while external demand has remained broadly weak. For most of 2010 we had a below-consensus growth forecast, which we attribute to our different perception of growth risks in Europe and the impact of that on Turkey's exports (of which some 57% is geared to Europe). We stick to our forecast for the time being as we have been witnessing clear signs of moderation in growth starting in 2Q and extending into 3Q. The industrial production data, consumer sentiment, business confidence and PMI all point to a deceleration in activity, and the ongoing weakness in the external backdrop clearly does not help. Our inflation forecast for end-2010 had been revised slightly downwards from 7.7% to 7% with food prices reversing course, although monetary policy remained looser than we were expecting. Our policy rate forecast of a 150bp hike at the start of this year has been revised downwards to zero and we expect a delayed response until 1Q11 (with risks skewed towards an even later date). This monetary policy shift was perhaps the most noteworthy surprise so far this year. Otherwise, we have remained sanguine about the external deficit (and the rather large financing requirement) as we believe that the widening in the current account in 2010 and 2011 will be satisfactorily financed via medium-term borrowing and to some extent with non-debt creating inflows. Nevertheless, we have been somewhat disappointed with the lack of sizeable FDI inflows. One of the strengths of the Turkish economy has been contained risks on the fiscal front and an improving budget performance. While this still remains the case, the recent decision to delay the implementation of the Fiscal Rule into 2012 did nothing but add more uncertainty to the risk profile, in our view.
Risks and events to watch: Looking ahead to the next six months, we consider the single most important event to be the referendum that will be taking place on September 12. Essentially, the public will be voting for or against a set of amendments in the constitution that the governing party, AKP, has proposed. The amendment includes various changes that would bring the Turkish constitution closer to EU standards in terms of democratic principals and individual rights; it broadly removes the influence of the military on day-to-day politics. While this seems like a straightforward matter, there are certain amendments regarding the judiciary that the opposition is against. Some of the changes proposed by the draft amendment package call for a significant change in the composition of the high courts as well as the appointment process for the future members - and it is this which has drawn criticism from the opposition. In the early stages of the parliamentary voting process one of the key changes in the draft package was rejected, and this was a first defeat for PM Tayyip Erdogan in terms of the proposed constitutional reforms. Essentially, the article in question was proposing to make political party closures, which resulted in some 26 closures in the past, very difficult. In early July, a second blow to the constitutional amendment motion came from the Constitutional Court, which annulled some aspects of constitutional changes that were designed to curb the powers of judges and prosecutors.
Political scenarios: At this juncture, the outcome of the referendum on September 12 is seen as a reference event that might give significant shape to the political climate, and hence affect the fiscal picture, heading into general elections scheduled for July 2011. In our view, there are four different scenarios that are worth examining: 1) If the referendum attracts strong support (i.e., >60%), the market is likely to take that as a cue for continued support for the governing party and to assume an AKP victory at the general elections. That would mean a single-party government which might suggest no accelerated election-related fiscal spending. From the markets' point of view that would be good news. 2) A narrow support (slightly above 50%) could result in a more or less market-neutral impact, with AKP capitalising on the success, albeit still having doubts regarding a sure-fire victory in the general elections. Hence, the market might stay sidelined but the fiscal risks would still remain in the background. 3) A narrow loss (slightly below 50%) would, in our view, indicate success on the part of the opposition and rising support for CHP (the main opposition party). In our view, the immediate impact of this would be market-unfriendly as it would raise fiscal concerns and bring post-election coalition scenarios to the foreground. 4) Strong opposition at the referendum (i.e., rejection with more than 60%) would clearly be market-unfriendly as it would surely be perceived as a sign of a lack of support for the government, raising the probability of a coalition government following the 2011 elections. The other assumption attached to this outcome would be to expect the government to potentially accelerate spending and resort to populist policies to counteract loss of power.
Poland: Still Outperforming, Potentially Leading the CEE Hiking Cycle
Our growth and inflation views in Poland have been largely vindicated this year. Growth outperformance has continued, and Poland managed to not only avoid recession altogether in 2009, but actually return to a 3% pace, which is not miles away from potential, we think. Industrial output is already back to the 2008 levels and retail sales growth, while more modest, never really reflected a recession (in contrast with the Czech Republic and especially Hungary). The inflation story has largely been tracking in line with our expectations also, except that the July trough was roughly 0.5% higher than expected at the start of the year, leaving us on track for inflation to climb to just below 3%Y by year-end. The most surprising event of the first part of the year, in our view, was the decision by the NBP to break with its ‘no intervention' policy in April, when EUR/PLN fell to around 3.83 (6% lower compared with January), and the NBP announced that it had purchased some FX in the market. We had always thought of the PLN as a ‘low intervention risk' currency. Evidently, the authorities objected to the pace of appreciation, though we still think they accept the secular medium-term appreciation trend for the zloty. The tragic loss of Governor Skrzypek in the April plane disaster, the change in risk appetite and subsequent move in PLN made the intervention debate rather irrelevant of course, but even under Belka's leadership we still think that fast PLN gains may attract either verbal or market intervention.
On the fiscal front, Poland has not made much progress. The busy electoral calendar (parliamentary elections in 2011) provides the government with an incentive to delay the inevitable tightening needed to cap the debt/GDP ratio at below 55% of GDP. According to the recently published fiscal plan, the deficit/GDP ratio should be brought under 3% in 2013 (no longer 2012), most of the consolidation in the budget will happen due to a 1% VAT hike, whereas the savings from the planned fiscal rule (discretionary spending up by inflation + 1%) look pretty modest. GDP growth is projected at 3.0% in 2010, 3.5% in 2011, 4.8% in 2012 and 4.1% in 2013 - perhaps on the optimistic side but not wildly so. Inflation is projected to gradually converge to the 2.5% target - again, this seems realistic if not too conservative. The state budget deficit (these are the monthly numbers released by the MoF, not the ESA-95 ones) drops from PLN 52.2 billion this year to PLN 30.0 billion in 2013; the borrowing needs drop even faster (from PLN 82.4 billion this year to PLN 38.6 billion in 2013), presumably because of privatisation proceeds, planned at PLN 30 billion in 2011-13. On the basis of these assumptions, the debt/GDP ratio stays a shade below 55%, a level which would automatically trigger pretty severe fiscal tightening. None of these assumptions seem outlandish; the only thing that we would stress is that everything needs to go pretty well (such as growth, privatisation and VAT receipts) for debt/GDP to stay below the crucial 55% threshold. Perhaps it was unreasonable to expect anything more aggressive than this during a busy electoral period, but Poland has chosen to walk a fine line on the fiscal front.
On the monetary policy side, our view is that Poland does not need fast rate increases, and the clear stance by the Fed and the ECB to keep rates low for long makes a strong case for central banks presiding over small open economies to adopt a similar line. That said, within CEE, Poland is a relatively more closed economy, with inflation headed back above target, lack of much slack in output and an improving labour market. It certainly does not appear odd that rates should be taken closer to neutral, even if the ECB and other regional banks stay on hold. That is why we maintain our long-standing forecast for 50bp of rate increases this year, most likely starting in October.
Hungary: Hostage to the Markets, Still Plenty of Risks, NBH Done with Easing
Earlier this year, we thought the defining event of 2010 would be the return to power of Fidesz and Mr. Orban. We viewed the potential for the discovery of ‘fiscal skeletons' as high, as any under-reported deficit could be attributed to the previous government. At the same time, we assumed that the new government would continue to work alongside the IMF and the EU. In the event, despite a lot of noise earlier this year, the government stuck to pretty much the same 2010 deficit target that had been agreed between the IMF and the previous administration (so, no major skeletons, after all). That said, the measures undertaken (i.e., the bank tax) and a disagreement over the 2011 target have meant that the IMF left Budapest in July without an agreement (see Hungary Economics: A Risky Bet, and the Odds Are Not Good, July 29, 2010). As we stressed in the past, Hungary's fiscal progress over the past few years has been excellent, and the country now boasts the strongest fiscal position in the EU. However, its high external debt stock, high private and public FX indebtedness, low growth, and its status as a high-debt country within the CEE make it still stand out as one of the weakest links across the region, in our view. So, while it is true that Hungary can fund itself from the market, it still faces around €9 billion of redemptions (plus of course net issuance) in bonds and external debt between now and end-2011. And of course, it has plenty of reserves (though note that some are just IMF money parked there) and an estimated €5 billion Min Fin funds in an account at the NBH. However, running down Min Fin cash and FX reserves in case markets seize up again hardly looks like an appealing strategy to us. In that sense, an IMF credit line, which we believe was on the table after the expiry of the current SBA in October, would have been a nice backstop facility to have if the markets turned sour.
The main pushback to these concerns that we have heard from investors is the view that "the IMF will be back. It cannot afford not to be". We agree with this; the only doubt we have is what would prompt the government to require IMF assistance again (i.e., a severe sell-off in HUF, for instance). The current posture of the Fidesz government seems to be that it can and wants to go it alone. Many assume that the tougher rhetoric towards both the Fund and the EU aims at gaining votes ahead of the October local elections. We are much less confident about this, and would highlight risks of a fundamental shift in policy: the new government has a two-thirds majority which offers many opportunities but also plenty of risks. Recent statements and decisions suggest to us that policymaking has become more erratic, which carries risks for investors. Recent ratings actions (S&P revised outlook to negative, Moody's placed Hungary for review) also seem to confirm this.
What could happen between now and the end of the year? Our strategists look for a correction in risk, which if it materialises is sure to adversely affect HUF. But domestic sources of risk could be: i) ratings action; ii) a convergence programme that shows a deficit well above 2.8% of GDP in 2011, the number initially agreed with the IMF; iii) the escalation of the conflict with Governor Simor, which has already caught the eye of the ECB, and possible official action by EU institutions against Hungary; and iv) signs that, even after the bank tax is collected, this year's budget deficit is still headed towards 5% of GDP, above the 3.8% target. In short, we think that the best-case outcome for Hungary is that markets remain as much in love with EM as they are now. But we see plenty of risks, and no room for complacency at all. Given this backdrop, and a likely upgrade to its inflation projection at the upcoming August meeting, we think that the NBH is set to remain firmly on hold here. But at this stage, we believe that the risks of a hike are higher than those of a cut. The bank's easing cycle has proceeded largely in line with how we had anticipated (just one more cut compared to the 5.50% trough we were expecting in January), but at this stage we see little room for more easing, if any.
Czech Republic: Near-Term Risks of Cut Still Exist
The Czech economy is the most manufacturing-intense in the whole of the EU and one of the most open. Earlier this year, we correctly anticipated that inventory accumulation and industrial output (therefore the external sector) would be the main growth driver this year. The economy accelerated to post a 0.8%Q growth rate in 2Q, following 0.5% in 1Q. We have found the resilience of car production a real puzzle, especially given lower euro area demand growth, but probably inventory rebuilding and strong EM demand (Asia) had a lot to do with it. Regardless, we are still on track for some moderation in 2H, and our full-year forecast for 2010 has not changed much since the beginning of the year (1.8% current versus 2.1% initially).
Where we have been truly surprised has been on the monetary policy front. At the start of the year, we expected some normalisation towards year-end, to see rates at 2%. Instead, we got another cut and the prospect of a long period at 0.75%. Clearly, the change in ECB rate expectations played a huge role here (Morgan Stanley forecast 50bp of ECB rate hikes in 2010 at the start of the year). And on the domestic side, the bank was less willing to accept CZK gains than we imagined, making dovish noises each time the currency gains accelerated beyond their subjective assessment of ‘fair' pace. The CNB is perfectly capable of hiking ahead of the ECB, but we think that the recovery is too tentative and muted and inflation is not really an issue for the CNB to want to take such a proactive stance. Confirming this, Governor Singer recently commented that the period of rate stability will be longer than previously assumed, due to a sluggish recovery. Our own forecast sees rates on hold until 2Q11, then rising gradually (75bp in 2011).
In the near term, we think if anything the risks are tilted towards another cut. We think the contribution from net exports will ease in the coming months (note the trade balance has already stopped improving), which means that the CNB's tolerance for a stronger koruna will certainly not increase. The CNB's inflation report gives us a useful benchmark: consistent with the inflation trajectory is a EUR/CZK level of 24.9 in 4Q10 and 24.1 in 4Q11. Therefore, we think a move in EUR/CZK below, say, 24 in coming weeks would change the risks around the inflation outlook enough to bring a rate cut back on the table.
Israel: Remains a Robust Story
We started the year with an upbeat view on growth and keep it intact with only a marginal upgrade of our real GDP growth forecast from 3.7% to 4%. Essentially, the loose monetary policy with negative real policy rates and the mild support from fiscal policy have kept the growth momentum broadly in place. The weakness in the euro zone placed a lid on export growth but nevertheless the current account remained in surplus and is unlikely to show a significant reversal in the near future. We keep our forecast of 2.2% of GDP for the current account unchanged. One of the key issues that we have drawn attention to in the past 12 months has been the record rise in FX reserves held by the BoI, which has been built up by the presence of a current account but more so due to the FX interventions of the central bank.
In our view, the BoI will continue its policy of occasional interventions in the market, especially closer to times of rate hikes, to stem the appreciation of the currency and provide support to exporters. However, we maintain our view that this is not a sustainable policy amid a process of rate normalisation. Hence, we expect the ILS to strengthen faster once the BoI gives up on artificially forcing the currency to remain weak.
Despite the highly accommodative monetary policy, inflation eased noticeably, and even performed better than we expected. However, the heating up of the housing market had been putting noticeable pressure on prices and we have turned more bearish regarding inflation in 2011 in comparison to early 2010. We expect average CPI inflation at 2.5%Y in 2010 and 2.9%Y in 2011. One of the reasons behind this has been the very slow ‘normalisation' of policy rates. We maintain our view that both nominal and real interest rates need to be raised as the economy clearly shows signs of robust growth and easing unemployment.
Russia: Higher Inflation and Slower Fiscal Consolidation Ahead
The economy had a better-than-anticipated start to 2010 and our GDP growth forecast is now marginally higher than that of January. Real GDP was up 5.2%Y in 2Q10, which translated into a 1.5%Q (sa) rise, compensating for the 0.9%Q decline in 1Q. Investment expenditure (the main driver of the contraction in 1Q) and consumption recovered in 2Q. Household confidence improved on the back of rising real incomes and the decline in unemployment. The contribution of net exports to GDP is likely to be less than we initially anticipated. Weakening of external demand (especially in EU) slowed down industrial production growth. Our 2010 real GDP growth forecast stands at 5.5%Y, but we acknowledge downside risks emanating from the weaker outlook for net exports and agriculture affected by the drought.
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