But incoming data have also suggested that global growth is slowing, which would spell trouble for gains in US exports. Echoing that worry, the diffusion index of export orders in the August ISM survey, while still a strong 55.5%, was the lowest in 2010. Non-defense capital goods orders and shipments decelerated dramatically in the three months ending in July - to 2.8% and 6.2% annual rates, respectively - which could represent weakness in overseas deliveries of capital goods as well as domestic investment outlays.
We think that weakness is either temporary or primarily domestic, and that trade tailwinds are coming. Indeed, the $7 billion narrowing in July's trade gap hints that these tailwinds are just offshore. Moreover, we think that surprises on both sides of the ledger will contribute to a narrower trade gap and thus to upside surprises in US growth. In our view, still-hearty gains in global domestic demand will promote more-than-proportional gains in exports, while a sharp moderation in US demand and inventories will slow imports dramatically. The combination should partly reverse the trade headwinds that hampered 1H and promote up to a full percentage point contribution from net exports to US growth in 2H.
Exports: Global Reacceleration. Surely, that improvement cannot come entirely through exports, as the 16-18% gains in real US merchandise exports over the past year are clearly unsustainable. After all, global growth has slowed, paced by slowing Chinese and other Asian economies as China's monetary restraint tempered its domestic demand. But it does appear that Asia's economies are beginning to pick up steam again as policymakers have either deferred policy tightening - in India, Korea and Malaysia - or taken their foot off the brake in the case of China, which is reviving both domestic demand and production.
That pattern underscores our view that, even as global growth slows from 4.7% this year to 4.1% in 2011, gains in US exports likely will outpace it. Three factors are important in that regard: 1) a shift in the mix of US exports toward faster-growing EM economies and Canada; 2) a global capex upswing; and 3) the Russian drought and export ban that will boost agricultural exports.
1. A shift in the regional mix. The share in US exports of goods and services delivered to Asia ex Japan, Latin America and Canada has risen significantly in the last decade, thanks in part to these countries' faster growth. Despite the global recession, the share of US goods exports going to countries other than Europe or Japan rose from 69% of the total to 73% over the past five years, while the share of US services exports going to those economies also rose 4 percentage points, to 46% over that period.
In addition, the dollar's ongoing decline on a real effective basis has given US exporters a competitive edge in those markets. Measured by the Fed's real effective trade-weighted exchange rate index relative to other important trading partners, the dollar has declined by nearly 19% from its peak in 2003. At the same time, local currency appreciation in those fast-growing trading partners has improved their terms of trade, thus boosting real incomes and fueling their demand and import growth.
2. Global capex revival? It's worth noting that global rebalancing of the sort we envision involves the potential for a significant upswing in capital spending, including in infrastructure, not just in EM economies but also in the developed world. As our colleague Joachim Fels likes to describe it, there is a lot of spare capacity, but it's in the wrong places and the wrong sectors.
That fits our script in three ways: First, an export-driven US recovery may require new growth in US supplying industries, including small and new businesses. Second, some of that investment will likely come in the form of foreign direct investment (FDI) in the US. Global investors will likely begin looking to strategic corporate US assets rather than our sovereign debt. Third, there is the time-honored ‘accelerator' mechanism: Global companies have reduced their older and less-productive capacity, and gross investment is rising simply to maintain the capital stock; in addition, they are replacing it with more productive capital. Those factors should benefit US capital goods producers exposed to global markets. As evidence, 2H capital spending in Korea and other Asian economies is rising by 20-30% over 1H; in response, Chinese and Korean imports accelerated in August, with US-sourced machinery and equipment a contributor.
3. Russian drought likely to fuel US agricultural exports. US exporters of farm products will likely fill much of the void created by the drought in Russia and the EU. In what appears to be a replay of the food price spikes in 2008, Russia's plight and its August 15 ban on exports of wheat and grains has thrown the global food grain supply balance into sharp relief. Indeed, the USDA reported this week that the shortfall in global grain output is depressing the supply and stocks of wheat and other feedgrains. Against the global backdrop of rising demand for meat and feedgrains to produce it, the bad news is that food prices may rise significantly further. The good news for US farmers is that this supply shortfall will boost exports; for example, the USDA projects a 1.4 million ton increase in US wheat exports, a 1.3 million ton increase in corn exports, and a 10 million bushel increase in sorghum shipments abroad.
Empirical evidence in two forms. Statistical relationships illustrate these points. We estimated the parameters of a simple relationship to explain growth in US exports as a function of growth in non-US GDP, plus changes in the real exchange rate and non-oil imports (the last variable represents the influence of ‘round-trip' trade on exports). Importantly, the estimated elasticity of real exports with respect to non-US GDP alone is about 2 - implying that, other things equal, 5% growth abroad will yield 10% growth in US exports. The elasticity of exports with respect to the real effective exchange rate implies that the 5% depreciation in the broad trade-weighted dollar over the past 30 months will add another 3.5% to exports. Those estimates are consistent with our view that US real merchandise exports will grow by 10% over the four quarters ended in 2Q11.
Imports: Leveraged to the slowing in US domestic demand. In contrast, we think that the significant slowing in US domestic demand will likely promote an even sharper deceleration in imports. That's because imports have been far outstripping domestic demand, and the recent surge has largely caught up to previous levels of import penetration or share. With final domestic demand slowing to an estimated 1.5% annual rate in 2H, imports henceforth should grow as slowly or more slowly than domestic demand, and additional monthly declines would not be surprising. Moreover, a shift in the mix of demand away from durables and a much slower pace of equipment spending likely will depress big-ticket-heavy imports.
Empirical evidence on imports supports that outlook. A simple relationship explaining the growth of real non-petroleum imports depends on the growth in consumer and equipment investment outlays, swings in inventories (which wash out over two quarters), the growth of exports (to capture and control for ‘round-trip' trade), and the real effective exchange rate. The elasticity of imports with respect to the domestic final demand components is 1.1, suggesting that moderate gains in demand will be associated with similarly moderate growth in imports. The model also suggests that the 2.2% decline in the real trade-weighted dollar over the past 12 months will trim about 2 percentage points from the growth in non-petroleum imports.
Trade and inventories. Swings in inventories have promoted even sharper swings in imports and magnified the widening in the trade gap. Just as sharp declines in imports cushioned the shock of production cuts in the recession - adding nearly 6 percentage points to output in 2Q09 - so has an import surge dampened recovery in domestic output this year. Some of that surge likely resulted from Chinese exporters accelerating shipments to beat the removal in July of export tax rebates on hundreds of items, including steel, fertilizers, glass, rubber and medicine. Those Chinese exports shipped here likely wound up in US inventories; as evidence, wholesale inventories jumped by 1.3% in July. Before ordering more, distributors will probably work off those imported inventories. And because the leverage (or magnification) between imports and inventories works both ways, we think that a temporary stalling in inventory accumulation will depress imports. In our view, imports are still out of line with fundamentals, and more slowing is on the way.
After a modest bounce Tuesday, Treasuries moved steadily lower over the holiday-shortened past week, extending a major market correction that began September 1 when the much stronger-than-expected manufacturing ISM report started a run of better economic data after a dreadful run in August. The past week's economic calendar was unusually quiet, but the improved tone continued in what was released, with a big narrowing in the trade deficit and upside in wholesale inventories leading us to boost our 3Q GDP forecast a half-point to +2.6% and jobless claims sharply extending a reversal of the upside seen in July and August that increasingly seems to be confirmed as a temporary census distortion. On top of the ongoing reduction in investor pessimism about the growth and inflation outlook, supply was a problem for the market over the past week, with 3-year, 10-year and 30-year auctions that ended poorly with a soft 30-year reopening Thursday. There was also supply pressure in the MBS market that led to significant underperformance on the week that weighed on the intermediate part of the Treasury curve after prepayments showed a sharper-than-expected acceleration in August, pointing to a ramping up of origination going forward. Corporate issuance was also heavy, and while this provided some support to rates markets during the short Tuesday pause in the recent sell-off as rate locks were unwound and the new supply swapped, it ultimately probably added to pressure on the market later in the week.
On the week, benchmark Treasury yields rose 6-10bp, with 5s and 7s lagging as mortgages underperformed. The 2-year yield rose 6bp to 0.57%, old 3-year 7bp to 0.86%, 5-year 10bp to 1.58%, 7-year 10bp to 2.23%, 10-year 9bp to 2.80%, and 30-year 9bp to 3.87%. So far this month, yields are up 9-34bp, with 2s-30s up 25bp, the first significant period of weakness since the five-month-long market surge began in early April. Accompanying the back-up in nominal yields and steepening of the curve has been a big move higher in inflation expectations in the TIPS market, with almost all of what was looking to be a significant deflation scare after the August FOMC meeting now having been reversed. On the week, the 5-year TIPS yield rose 1bp to 0.17%, 10-year fell 4bp to 0.99%, and 30-year rose 1bp to 1.71%. This left the benchmark inflation breakeven up 13bp on the week at 1.81%, a high since the 1.85% close on August 10, the day of the FOMC meeting after a disturbingly abrupt move down to a low since spring 2009 of 1.52% on August 24. Shorter-end TIPS have not seen as much outperformance, so forward measures of inflation expectations that the Fed has been known to focus on more have normalized even more, with 5-year/5-year forward inflation breakeven up about 40bp from the August 24 low to near 2.20% - which is pretty much exactly what our point estimate is for what CPI will average from between 5 and 10 years from now.
Mortgages performed badly on the week, with parts of the market lagging the significant Treasury market sell-off meaningfully, after August MBS prepayment results showed a significantly faster-than-expected acceleration, raising fears of sharply rising origination supply if the refi wave that seems to be underway continues. The worst-performing parts of the MBS market were the 4.5% to 5.5% coupons that saw the most upside in prepays, but lower coupons also lagged slightly, leaving current coupon MBS yields up about 10bp to near 3.55%, a high since the first week of August after a 35bp rise since the August 31 record low. Primary/secondary mortgage spreads have narrowed somewhat as a result of this sell-off, but they started at very wide levels, so this shouldn't necessarily translate into significant upward pressure on 30-year mortgage rates for now. Still, with the prospect of a refinancing wave leading to a big pick-up in mortgage origination activity and new supply of lower-coupon MBS, we think it would be sensible for the FOMC to shift its reinvestment policy at the upcoming FOMC meeting and start buying MBS along with its ongoing Treasury purchases with the proceeds from MBS and agency maturities. These purchases should be significantly higher in the second month of revived buying from mid-September to mid-October. The accelerated MBS prepay rates reported for August point to about a $25 billion rundown of the Fed's portfolio on top of about $5 billion in agency maturities, so the New York Fed will need to reinvest about $30 billion after the $18 billion bought from mid-August through this week.
Risk markets traded conversely to rates markets through the week, giving back some ground Tuesday but then rallying through the rest of the week. The upside from Wednesday to Friday was much more muted than the move in rates, however, as equity and credit markets only managed marginal gains for the week as a whole while Treasury yields ended up significantly extending the initial reversal in the first few days of September. For the week, the S&P 500 ended up 0.5%, with similarly muted performances across major sectors. Credit upside was also minor, with the IG CDX index tightening 1bp to 103bp and the HY index improving 5bp to 554bp.
The past week's economic calendar was very light, but the key numbers that were released extended the improved run that began with the ISM release on September 1. The most notable release was the foreign trade report. The trade deficit narrowed $7 billion in July to $42.8 billion, almost fully reversing an $8 billion surge in June, as imports pulled back 2.1% after surging 3.1% and exports rebounding 1.8% after falling 1.3%. This big reversal of the surge in the trade gap at the end of 2Q puts net exports on pace to add significantly to 3Q GDP after the huge 2Q drag. We now see trade adding 0.7pp to 3Q GDP growth, up from our prior +0.3pp estimate, reversing a small portion of the near-record 3.4pp (exceeded only once, in 1947) subtraction in 2Q. On top of the trade upside, inventories also appear on pace to provide a good boost in 3Q. Wholesale inventories surged 1.3% in July after the 1.0% gain reported for the factory sector last week, as some of the shockingly strong import growth in 2Q that seemed way out of line with demand growth and inventory accumulation may be showing up with a lag early in 3Q. Incorporating this result, we now see inventory accumulation adding 0.9pp to 3Q growth, up a couple of tenths from our prior estimate. Combining the better outlook for trade and inventories and a continued expectation that final domestic demand growth will slow to +1% from +4.3%, we raised our 3Q GDP forecast to +2.6% from +2.1%.
The calendar is a lot busier in the upcoming week, and the key activity measures, retail sales and IP, are likely to extend to more positive recent run of data. Notable data releases include the Treasury budget Monday, retail sales and business inventories Tuesday, industrial production Wednesday, PPI Thursday and CPI Friday:
* We expect the federal government to report a $94 billion budget deficit in August, $10 billion narrower than in the same period a year ago, reflecting a modest pick-up in tax receipts, partially offset by slightly higher outlays. With one month left in the fiscal year, we see the FY 2010 budget deficit at $1.315 trillion - or 9% of GDP. The deficit should continue to shrink in coming years due to cyclical forces, but there is a considerable amount of policy uncertainty at this point clouding the outlook.
* We forecast a 0.3% rise in overall retail sales in August and a 0.6% gain ex autos. The motor vehicle sales reports point to a dip in the auto dealer category. But chain store results were strong - likely aided by expanded sales tax holidays in some key states. So we look for a solid gain in sectors such as apparel and general merchandise, leading to an expected 0.5% rise in the key retail control gauge. Finally, we should see another price-related gain at gas stations.
* Very sharp jumps at both the manufacturing and wholesale stages point to an outsized 0.9% rise in overall inventories in July. Also, June should be revised a bit higher. Still, the I/S ratio should hold at a low 1.26 in July, reflecting the lack of any inventory excess at present.
* We forecast a 0.5% gain in August industrial production. Even though the employment report showed a drop in manufacturing jobs during August, the average workweek ticked up. In fact, the hours data point to a solid rise in output. In particular, we look for sharp gains in sectors such as computers, electrical equipment and chemicals. Meanwhile, motor vehicle assemblies retraced some of the sharp jump seen in July, when many plants skipped their usual summer shutdown. So, we look for a solid 0.6% rise in the key manufacturing category and a 0.8% jump in manufacturing excluding motor vehicles. Finally, the utilization rate is expected to hit a new 22-month high.
* We look for a 0.7% surge in the headline producer price index in August and a 0.1% uptick ex food and energy. A rebound in the energy component, along with another jump in food prices, is likely to push up the headline PPI this month. Meanwhile, the core should be better behaved than in July when higher quotes for motor vehicles and prescription drugs helped to trigger some upside.
* We forecast a 0.3% rise in the overall consumer price index in August and a 0.1% rise ex food and energy. Gasoline prices are expected to post another sharp jump this month. Also, food prices appear to have begun to head higher, led by significant upside in quotes for grains and beef. Meanwhile on the core, as we have been highlighting in recent months, the key shelter component - which accounts for more than 40% of the core - appears to have bottomed. Indeed, a turnaround in shelter is consistent with increasingly widespread evidence of lower rental vacancies and rising rents. Finally, note that our August estimate implies an uptick in the year-on-year core CPI rate, to +1.0%. This would be the first uptick since last December and, from our standpoint, reflects a meaningful trend reversal in core inflation.
Solid Growth Now, but Slower Growth Ahead
The first preliminary Apr-Jun GDP data were unexpectedly weak, but the revised figures exceeded the potential output growth rate, seen now as just below 1%. The trend for Jul-Sep appears generally favorable, especially for personal consumption, thanks to policy stimulus and the heat wave. Fears about a double-dip for the global economy are also receding slightly, with sentiment indicators for manufacturing in the US and China recently picking up. We had not been forecasting a double-dip for Japan anyway, but recent economic indicators have finally provided backing for this view.
Concerns have not been cleared, however. Eco-car subsidies that supported consumption in Jul-Sep have ended before the end-Sep deadline, and we expect domestic auto sales in Oct-Dec to plunge close to 40%Q. Downside for domestic production appears likely, primarily for automobiles. A reaction following the cigarette demand spurt ahead of the hike in tobacco tax from October cannot be ignored either. The Eco-point program for home electronic appliances has been extended to Jan-Mar 2011 in streamlined form, but when that expires from Apr-Jun 2011, durables consumption will suffer in the absence of front-loaded demand.
Thanks to the demand spurred by such policies, we expect bumpy moves in quarterly consumption between Oct-Dec 2010 and Apr-Jun 2011. Especially for the Oct-Dec quarter of 2010, we are likely to see near-zero growth. However, F3/12 should see the large increase in corporate earnings during F3/11 finally translate into higher numbers of employees, and summer bonus payments may show a relatively powerful recovery. We expect improvement in the wage and income environment to avert a consumption bottom, even when policy stimulus fades, and look for spending levels to build gradually from the Jul-Sep 2011 quarter.
Externally, exports to Asia which have underpinned the post-Lehman recovery have been generally flat since the start of 2010, and exports appear less able to drive the economy than before. The recovery in exports to the US has been subdued, and pre-Lehman shock levels have yet to be regained. However, the political cycle in both the US and China is moving towards a peak in 2012, and there is potential for support for the economy from fiscal policy at an early stage if needed - in Oct-Dec 2010, or during 2011 - which would be favorable for Japan's exports.
Given this, we think Japan's economy is likely to recover gradually during 2H F3/11 and F3/12 with support from wage/income conditions and the external environment, despite having to absorb the negative effects of waning policy demand. The actual growth rate may fall for technical reasons in F3/12 due to a lower base effect, but we do not envisage the economy sliding back.
There is some concern that the yen's recent strength threatens to cause a slowdown, but as long as the yen appreciates gradually, we think this is unlikely to be fatal for Japan's economy. This is because the real effective exchange rate adjusted for the gap between domestic and overseas inflation rates still indicates the yen is still considerably cheaper than in April 1995, when the yen was ultra-high. In the Apr-Jun corporate results season, guidance for manufacturing industry recurring profits to increase by about 70% in F3/11 was also maintained under conditions of a strong yen. In the last 15 years since 1995, Japanese manufactures have stepped up their offshore production, resulting in earnings being more resistant to currency swings. This ability of companies to adapt to a strong yen should not be underestimated.
As a result, though we expect Japan's economy to slow to 1.0% in 2011 from 3.0% in 2010, partly due to a technical factor (i.e., a lower base for the year), we forecast the economy to maintain growth slightly above its potential growth rate, seen as just below 1%, for two years in a row. Nominal growth should underperform real growth during this period, however, with the GDP deflator remaining negative year on year. Prices are becoming extremely unresponsive to changes in the output gap, so we expect the timing of the exit from deflation to be 2013 or beyond, as discussed later.
Upside and Downside Risks to Our Forecast
The risks to our outlook are political factors. Depending on the outcome of the DPJ's leadership election, the current policy of spending restraint could be temporarily replaced by an expansionary bias with emphasis on the expenditure commitments made in the manifesto. For example, former DPJ secretary general Ichiro Ozawa has pledged to increase child allowances in F3/12, to implement the full program for child allowances from F3/13, and to build a highway network across the country. This represents an upside risk to our forecast, as such steps would boost demand ahead, but only for the short term.
Whatever the outcome of the leadership election, the next administration may prove short-lived. The DPJ contest is drawing attention, but will do nothing to alter the division of party control between the upper and lower houses. And since the ruling parties do not have a two-thirds majority in the lower house, they are unable to overturn decisions made by the upper house. In this situation, there is a low probability that budget-related legislation would take effect in the upper house even if F3/12 budget proposals were passed by the lower house. The government may have to trade passing budget legislation for dissolving the Diet and calling a general election.
In this light, we believe that the government's fiscal policy is not likely to be expansionary over a sustained period, even if it turns in that direction for a time.
Downside risks relate to overseas. Our house global economic forecasts are quite bullish relative to the consensus. Risks to our outlook could be Japan-style deflation in the US and the flaring up again of sovereign debt problems in Europe, threatening lower growth rates. For the former, our US team does not expect the US to drop into deflation, one reason for this being employment and wage-setting mechanisms which are different from those in Japan. US employment practices which prioritize adjustments of jobs ahead of nominal wages do indeed make Japan-style wage deflation more unlikely.
For the sovereign debt problem, our European economics team believes that the recent stress-test announcements have ended the bad news for the time being. But far from resolving the problems, the stress tests have led to lingering uncertainty for the future by postponing the framework for comprehensive capitalization of financial institutions. We note the possibility that sovereign credit uncertainty could recur in 1H11.
Extremely Sluggish Pace of Price Recovery
Our price outlook has been cautious from the start, and we have highlighted the possibility that underlying prices - excluding fresh foods, energy, and the impact of systemic factors - will remain negative year on year until around the end of 2013. Although the underlying inflation in year-on-year terms bottomed in Jan-Mar 2010, the recovery thereafter has been listless.
In macro terms, there is a time lag of about three quarters between the output gap and underlying price trends. The output gap has been improving gradually from the region of -8.3% in Jan-Mar 2009 to -4.8% (Cabinet Office estimate, preliminary) in Apr-Jun 2010, and the bottoming of core prices in Jan-Mar 2010 is consistent with this.
However, concerns are unabated. We estimate that medium-term inflation expectations have improved marginally from negative levels in Oct-Dec 2009, but are still virtually zero. This depressed levels poses risk that investment and consumption by the household and corporate sectors will be consistently postponed, prolonging demand stagnation, delaying improvement in the output gap, and thereby causing deflation to drag on.
In the near term, there is concern that revision of the base year for CPI statistics could exacerbate deflation, albeit as a technical issue.
Monetary Policy Still in an Accommodative Cycle
The economy is trending ahead of its potential growth rate seen as just under 1%, but given the huge output gap, it is tough to envision an early end to deflation, and we expect the government to continue to press the BoJ for further easing. The BoJ for its part is likely to basically cooperate, to avoid losing its independence via revision of the BoJ Law. We see the timing of further easing as Oct-Dec 2010, with potential triggers being 1) additional easing by the Fed, and 2) the JPY/USD trend. Given the constraints of zero interest rates, the conventional options for further easing are not extensive, but as means for the BoJ to effectively conduct easing while preserving face (given its reluctance to adopt zero interest rate policy), we can envision: 1) transitioning to a guidance band for the unsecured overnight call rate (0-0.1%); and 2) raising the balance of current account deposit reserves.
We think Oct-Dec 2012 or beyond is the exit timing. The benchmark year for the CPI will be revised in August 2011 (using 2010 for the nationwide data from July 2011), and as the rates of decline in the revised index are expected to be amplified, we postponed our outlook for exit timing when revising our interest rate forecast recently.
Meanwhile, long-term yields have come down, consistent with the global trend of fiscal retrenchment and fears of a double-dip for the global economy, and the 10y JGB yield hit our year-end target level of 0.90% on August 25. There has recently been a period of correction, due to concerns over fiscal expansion and profit-taking by financial institutions brought about by falling stock prices. However, the deflationary domestic environment is unchanged, and systemic and accounting factors also argue for lower interest rates, so we believe that the trend remains downwards. We keep our year-end target of 0.90%.
For details, see Japan Economics: Trimming 2011 Outlook with Policy Effects Wearing Off, September 10, 2010.
There Can Be No Mistaking How Hard Ireland Was Hit...
Nominal GDP (gross domestic product) has collapsed by 22% from its pre-crisis peak in autumn 2006. GNP (gross national product), which in the case of Ireland is a more appropriate metric, has declined even more steeply, losing a total of 27% over the same period. House prices have fallen by ~40%, wider consumer prices by ~5% and wages by ~6%. Public sector debt is on the steepest rise anywhere in the euro area and the budget deficit is deep in the red and, at best, hovering sideways for now.
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