1. MSBCI composite index signals expansion. First, the MSBCI composite index, which is similar to the ISM composite index, stood firmly in expansion territory. Indeed, this recently introduced composite picked up five percentage points to 64% this month.
2. MSBCI components universally supportive. In addition, building upon last month's improvement, the underlying components of the September canvass were universally supportive. Most notably, the advance bookings index rebounded by 10 percentage points from the critical 50% mark to 60% this month. These gains were primarily driven by stabilization in healthcare and information technology and growth in materials and consumer discretionary companies.
The pick-up in consumer discretionary advance bookings is significant and suggests that consumption will not continue to depress US output through 2011. As we have previously argued, US households have deleveraged their balance sheets and rebuilt savings over the past two years (see Deleveraging the American Consumer: Faster than Expected, August 20, 2010). Consequently, we do not foresee consumers retrenching again as the result of overly burdensome debt-service payments. Although tepid gains in household wealth will likely restrain consumer spending growth to a 2-2.5% pace for the second half of this year and next - well below the 1970-2007 average of 3.4% - the relatively sanguine outlook for cyclical sectors such as consumer discretionary is an encouraging sign.
Just as important, the credit conditions index equaled the August reading of 64%. Similar to the recovery in advance bookings in this month's survey, credit conditions teetered on the precipice of contraction in July and then bounced back into expansionary territory the following month. This month's positive result affirms the validity of the August rebound in credit conditions.
3. Breadth of improvement impressive. Third, the broad-based strength in this month's survey offers plenty of reasons for optimism. For instance, the companies under our analysts' coverage maintained their pricing power. The price index was measured at 62% in September - on par with the August reading. Likewise, employment continued to improve: In a nine-point gain over the previous month, over a quarter of respondents indicated that their firms had stepped up hiring over the past three months - lifting the hiring diffusion index one point to 53%. And the hiring plans diffusion index rose four points, as 28% of analysts expected their companies to expand payrolls through the end of the year. Similarly, business investment should carry on at a hearty clip through the rest of 2010; the capital expenditures plans diffusion index increased another four percentage points from 67% to 71%, as 44% of survey respondents anticipated that their companies would boost investment in 4Q10. Finally, the outlook going into 2011 remains promising. The business conditions expectations index soared 12 percentage points from 66% to 78% in early September - reversing six straight months of declines.
Top line better but earnings outlook is murky. However, our analysts presented a decidedly more murky outlook on their firms' earnings in the September canvass, likely reflecting the nosebleed level of profit margins at many companies. On the bright side, fewer than 10% of survey respondents indicated that the quality of their companies' earnings had deteriorated over the past year. Nevertheless, about 14% of analysts believed that their firms' margins would shrink in 2010 - the highest such response since we first began asking this question last December. Moreover, nearly 49% of respondents perceived downside risks to their earnings estimates - retracing the previous month's sharp improvement. And over 53% cited lower costs - rather than higher top-line growth - as the primary reason why companies exceeded earnings estimates. With corporate profits already back to pre-recession levels in 2Q10, a downshift in the pace of earnings growth is not unexpected. Still, these developments certainly bear further watching in the months ahead.
Long list of policy uncertainties. In spite of various uncertainties that have weighed on economic growth over the past year, our analysts gave little indication that these headwinds had materially altered business conditions.
Among them:
• Healthcare reform: Although only 30% definitively stated that uncertainty over the implementation of healthcare reform was not hindering their firms' hiring, the percentage of survey respondents who advocated the contrary viewpoint remained in single-digits.
• Financial regulatory reform: In a somewhat surprising development, only a third of analysts from the financials sector claimed that uncertainty over regulatory reform had affected their companies' decisions to either lend or expand - the lowest such response since we began asking this question in February 2010. This may reflect the growing clarity around regulations such as the just-released Basel III capital standards.
• Taxes: On par with previous results, approximately 20% of respondents reported that uncertainty over potential tax increases was creating hesitation to invest or expand among companies under their coverage.
• Market turmoil: For the first time since June, the majority of analysts indicated that firms under their coverage had not downgraded their assessments of business conditions. Furthermore, fewer than 10% stated that the recent volatility in financial markets had been a major factor in their firms' evaluations.
• Excess corporate cash: In line with earlier responses, over 40% stated that firms intended to return their record high levels of cash holdings to shareholders in the form of dividends and stock buybacks, and another quarter of analysts believe that their companies will utilize this working capital to expand operations through mergers and acquisitions. Interestingly, about 26% of survey respondents claimed that firms under their coverage had recently announced expansion plans and then been penalized by investors as a result. Thus, a fear of possible shareholder retribution may be deterring firms from accelerating their pace of capital spending and hiring. We see that as reinforcing capital discipline - a plus for margins.
• Structural obstacles to hiring: As we have frequently noted, a mismatch between the skills that workers currently possess and those that firms are ideally seeking has long been an obstacle to hiring (see Employment Prospects and Policies to Improve Them, February 26, 2010, and Why Is US Employment So Weak? July 23, 2010). The September canvass offered additional evidence to support this view. Nearly a quarter of survey respondents reported that their firms had recently been unable to find new employees with the necessary skill sets.
• New initiatives to aid the recovery: In light of President Obama's recently announced initiatives to spur business investment, we asked our analysts to gauge the potential near-term impact of these policies on their companies. With respect to the proposal to allow businesses to fully expense new equipment purchases through 2011, a little more than a third of respondents indicated that firms under their coverage would step up investment over the next 12 months. However, fewer than 20% believed that their companies would increase investment in response to an expansion and permanent extension of the research and development tax credit.
Economy Still Performing Well, but Set to Lose Momentum
The global economic outlook remains highly uncertain, but we expect the September Tankan survey results (TBA at 8:50AM on September 29 JST) to show a sixth successive improvement in the business conditions DI for large manufacturers. That said, this headline DI is somewhat backward-looking in the sense that it simply reflects corporate sentiment at the time of the survey, and we expect firms to be somewhat more cautious regarding the near-term outlook as they contemplate a deterioration in US economic indicators, diminishing policy-driven demand on the domestic front, and the potential ramifications of a strengthening yen. We think the points worth watching in the Tankan results will be the outlook DI rather than the headline. In fact, we expect the Japanese economy to slow to near-zero growth in 4Q10. This prospect is consistent with a sharp fall in the DI for current economic conditions in the Cabinet Office's Economy Watchers Survey for August.
We therefore expect the Bank of Japan's October Outlook for Economic Activity and Prices (TBA on October 28) to show a downward revision of the central bank's economic assessment, and believe that further easing measures could be announced at that time at the earliest. Possible courses of action include the introduction of a target band for the policy rate, the adoption of some form of inflation target, and a further increase in the BoJ's outright JGB purchases. We would not expect these measures alone to be sufficient to alter the overall direction of the foreign exchange and equities markets, but they could be effective, for example, if implemented with the MoF's FX intervention, provided that US economic indicators show signs of improvement. We remain cautious about whether US indicators will actually start to pick up by then, though.
Business Conditions DI Forecast: Headline to Show Further Improvement, but Outlook DI to Be Somewhat More Bearish
We expect the headline business conditions DI for large manufacturers to show a sixth successive improvement in sentiment, although the pace of improvement is likely to have slowed significantly in view of the strong yen, a slowdown in exports to Asia, and the prospect of a further decline in policy stimulus. We also expect the outlook DI to be lower than the business conditions DI in light of these risk factors, which would mark the first time that this has occurred since the December 2008 survey (conducted soon after the collapse of Lehman Brothers).
The business conditions DI for large non-manufacturers is also likely to show a sixth consecutive improvement, reflecting strong consumer spending in the July-September quarter as government stimulus measures continued to fuel demand. That said, we also expect the outlook DI to point to a deterioration ahead.
Given the aforementioned deterioration in the DI for current economic conditions in the Economy Watchers Survey (a leading indicator), it is unclear as to whether the business conditions DIs for smaller firms will show further improvements. The outlook DIs are almost certain to be somewhat bearish, however, thereby continuing the trend that began with the March survey.
Input and output price DIs should show profit margins deteriorating at a slightly slower pace, with continuing downward pressure on manufactured goods prices likely to be offset to at least some extent by the recent stability of commodity and energy prices as well as a softening of input prices attributable to the strong yen.
In terms of direction, DIs relating to the output gap such as production capacity and employment are likely to show that the sense of excess slack is peaking out, but in terms of level we expect strong signs of capacity surpluses to persist.
Our Forecast for F3/11 Business Plan Revisions
1) F3/11 Sales and Profit Forecasts to Be Revised Only Slightly
Given that firms have yet to finalize their first-half financials, we expect the September Tankan results to show only relatively minor adjustments of sales and profit forecasts.
Firms generally revise their sales forecasts only slightly higher (if at all) when the economy is expanding, and also tend to make relatively small downward revisions during economic downturns. Similarly, firms will usually upgrade their profit forecasts during upswings and downgrade them during recessions (although F3/10 was clearly an exception in both cases). That said, other than in F3/02, September surveys have tended to show only relatively small revisions in either direction.
History therefore suggests that the upcoming Tankan results will show sales forecasts revised upwards by less than 1%, while profit forecasts should also show an upward revision in the order of 1%. This would translate into little change from the June forecast, pointing to a roughly 22%Y increase in profits for large firms, but while this appears somewhat conservative given that our top-down analysis currently points to ordinary profit growth of around +50% on a parent-only basis, it is important to recognize that consolidated and non-consolidated forecasts defy simple comparison.
While exporters are now somewhat better equipped to cope with a strong yen than might previously have been the case, they have nevertheless struggled to keep pace with recent fluctuations in spot exchange rates. Our own calculations indicate that improved capacity utilization and a decline in input costs should have lowered the breakeven USD/JPY exchange rate for exporters to around 89 in July-September (down from 91 in April-June), which suggests that some exporters may feel themselves to be struggling at current exchange rate levels, although we should of course stress that the yen's real effective exchange rate is still considerably cheaper than in April 1995.
2) F3/11 Capex Plans to Show Small Upward Revision as Historical Sept. Average
F3/11 capital investment plans are also likely to show relatively little change from the June survey. In September surveys, capex plans tend to be revised up a little in good times and down in recessions. With GDP estimates for April-June already confirming a third-consecutive increase in private non-residential investment, we expect the September survey to show full-year spending plans revised upwards only slightly as the historical September average.
Domestic capex remains muted, however, with spending by overseas subsidiaries accounting for much of the recent increase in investment activity. Once again, differences between consolidated and non-consolidated figures make it somewhat difficult to obtain a clear picture as to the true level of domestic capital spending. At this point, we see little prospect of a fully fledged recovery in domestic capex, despite it having already dropped below the level of depreciation, and we are anticipating that large firms will be projecting a 4.6%Y increase in fixed investment on an all-industries basis (revision: +0.2%), breaking down into +4.0% for manufacturers (revision: +0.1pp) and +4.9% for non-manufacturers (revision: +0.3pp).
In addition to the aforementioned discrepancy between consolidated and non-consolidated data, the relatively slow recovery in corporate capex - by comparison with previous economic upswings - would appear to reflect a somewhat sluggish improvement in capacity utilization, which looks to have stalled in the 70-75% range (leaving it on a par with the historical average for economic downturns) now that production activity has started to lose momentum. In stark contrast to what followed the collapse of the IT bubble, there is even some evidence to suggest that overall manufacturing capacity has increased rather than (as one might expect) being cut back in a bid to improve utilization levels.
Policy Implications: Further Monetary Easing Appears Likely
The BoJ's ‘emergency' policy response of August 30 - which was limited to an expansion of its fixed-rate funds-supplying operation - has been widely criticized as ‘too little too late', prompting the central bank to take a slightly more flexible line by indicating in this month's (September 7) Statement on Monetary Policy that it will "if judged necessary, take policy actions in a timely and appropriate manner".
The economy appears set to suffer a significant loss of momentum in October-December 2010 as consumption drops away following the removal of auto purchase incentives and an increase in the cigarette tax (effective October 1). Prime Minister Naoto Kan's re-election at the September 14 Democratic Party of Japan leadership election suggests that the overall direction of currency management and fiscal policy is likely to remain largely unchanged, and with a US economic slowdown raising the prospect of further easing measures by the Fed, continued upward pressure on the yen (and the associated downward pressure on stock prices) would probably see the BoJ face increasingly heated government demands for support on the monetary policy front.
We thus expect to see some form of additional easing in 4Q. The first step is likely to be a downward revision of the BoJ's economic assessment in the October Outlook for Economic Activity and Prices (TBA on October 28), at which time the BoJ will probably consider measures such as: 1) shifting to a target band (0-0.1%) for the uncollateralized overnight call rate; 2) adopting some form of inflation target or taking other action to strengthen the so-called ‘policy duration effect'; and 3) increasing its outright JGB purchases. Given that its previous expansion of the fixed-rate funds-supplying operation fell short of the market's expectations and was criticized for triggering further declines in USD/JPY and stock prices, we expect that the BoJ will be keen to ensure that its next step is seen in a somewhat more favorable light.
RBI hikes policy rates: The Reserve Bank of India (RBI) in its mid-quarter review of monetary policy today hiked the repo rate by 25bp to 6% and the reverse repo rate by 50bp to 5%, versus our and consensus expectations of a 25bp hike in both these rates. The repo rate is the rate at which the RBI provides liquidity to the commercial banks and the reverse repo is the rate earned by banks on the excess liquidity parked with the RBI. Including today's measure, the spread between the policy rates has narrowed to 100bp.
RBI confident on growth outlook: The policy statement highlighted that the recovery is consolidating and the economy is rapidly converging to its trend rate of growth. The better monsoon situation so far compared to last year holds prospects for good agriculture growth. In addition, all leading indicators of service sector activity point to sustained growth. We maintain our view that GDP growth will accelerate to 8.5% in F2011 (12-months ended March 2011) from 7.4% in F2010.
The RBI's cumulative policy action seems to begin to address the three macro stability risks: We have been arguing for some time that the policy rates need to move faster towards a neutral rate to ensure that the macro stability-related risks are managed well. In that context, we have highlighted three key symptoms reflecting low policy rates and a large push to domestic demand from high government expenditure to GDP. These symptoms include:
a) High inflation pressures in the context of tight capacity utilization and high non-food inflation: The headline Wholesale Price Index (WPI) accelerated to 8.5%Y in July 2010, after touching a low of -0.7%Y in June 2009. While food inflation has started moderating, non-food inflation remains high at 7.7% in July 2010. The RBI statement also highlighted that "Essentially, inflation rates have reached a plateau, but are likely to remain at unacceptably high levels for some months. While prices of food articles, which according to the new series, rose by over 14% in August, are still contributing to the pressure, about two-thirds of the August inflation can be attributed to items other than food articles and products. Notwithstanding slight moderation in August 2010, the headline inflation remains significantly above the trend of 5.0-5.5% in the 2000s." We expect headline WPI inflation to moderate to below 6% by end-March 2011 on a base effect. Non-food inflation, on the other hand, should remain around the 6.5% level by end-March 2011 (above the RBI's comfort zone). We believe that inflationary expectations will be contained as long as the RBI stays on the path of rate hikes.
b) Gap between credit and deposit growth: While bank loan growth was at 19.4% as of the fortnight ended August 27, 2010, the deposit growth was low at 14.4% during the same period. The gap between credit growth and deposit growth has been widening until recently. Currently, the banking system loan-deposit ratio is already high at 72.2% as of August 2010. Similarly, the 12-month trailing banking system loan-deposit ratio is already tracking close to 95%. Considering that the statutory liquidity ratio is 25% and the cash reserve ratio is 6%, we have been highlighting that there is a need to significantly accelerate deposit growth so that the system has adequate liquidity to support this rising credit demand. Consistent with our view, today's policy statement also highlighted the need to end the prevalence of negative real interest rates due to low deposit rates and higher inflation. In this context, we believe that the policy rate hikes are beginning to push banks to hike deposit rates - a step in the right direction, in our view.
c) High level of current account deficit: Over the past two quarters (ended Dec-09 and Mar-10), the current account deficit shot up to 3.8-4% of GDP, annualized, due to low real rates and loose fiscal policy pushing up domestic demand at a time when capacity creation was impacted by the global credit crisis. We believe that the current account deficit (annualised run rate of US$52 billion during the quarter ended March 2010) is already at a level where dependence on capital inflows is high. However, we think that over the next 9-12 months, as new production capacity is commissioned and the savings rate recovers with a rise in interest rates, the current account deficit will start narrowing.
In the near term, inflation and current account deficit risks remain: As discussed above, we expect the macro stability risks to reduce over the next 9-12 months as policy makers stay on course to tighten monetary policy and fiscal policy.
However, in the near term, we believe that the country will stay exposed to risks of any major risk-aversion in the global financial markets and consequent slowdown in capital inflows or any major rise in oil and global commodity prices. Any strong revival in G3 could push growth and commodity prices higher and any major deceleration in growth could cause risk-aversion. In the near term, any decline in capital inflows or sharp rise in oil above US$90bbl will likely cause exchange rate depreciation - only adding to inflationary pressure hurting growth. In other words, policy makers will get time to contain the macro stability risks as long as we see AAA (ample, abundant and augmenting) liquidity and a BBB (bumpy, below par and brittle) recovery in the developed world.
Bottom line: A total 125bp hike in repo rate has narrowed the gap between operative policy rates and neutral rates to about 25-50bp. However, we believe that domestic growth and inflation dynamics will warrant that the RBI stays on the course of policy rate hikes over the next six months unless there are signs of a major deceleration in developed world growth. Our global economics team does not expect any major slowdown in developed world growth. We expect the RBI to hike policy rates again by 25bp at its next monetary policy meeting on November 2, 2010.
Marking to Market - GDP Upgrade
Malaysia showed robust growth in 1H10 (+9.5%Y), the highest rate in a decade. 1Q10 GDP growth of 10.1%Y and 2Q10's 8.9%Y brought the economy 4.7% above the recent pre-crisis peak (2Q08). The strong growth in 1H10 was driven by both domestic demand (+16.4%Y versus +2.7%Y in 2H09) and external demand (+16.5%Y versus -4.1%Y in 2H09). All the sub-segments of domestic demand, viz., private consumption (+6.5%Y versus +1.5%Y in 2H09), government consumption (+6.6%Y versus +4.3%Y in 2H09) and fixed capex (+9.4%Y versus -0.6%Y in 2H09) showed acceleration. More important, after taking into account the contribution from re-stocking, a strong rebound was observed in capex (57.0%Y versus +4.8%Y in 2H09), the highest gain since data became available (June 1992). Indeed, inventories contributed a substantial 7.2pp to the headline GDP growth of +9.5%Y. To take into account the strong 1H10, we are marking to market our GDP forecasts to +7.2%Y (from our earlier forecast of +6.5%Y). However, we are leaving our 2011 forecast unchanged at +5.0%Y. With this upgrade, we are broadly in line with consensus (+7.0%Y for 2010 and +5.2%Y for 2011).
A Growth Moderation Going Forward
The GDP upgrade incorporates not only the strong 1H10, but also our view of growth deceleration towards a more normalized trend path in 2H10. We believe that the peak of the percentage year-on-year growth trajectory is behind us, with growth moderation ahead as base effects become less favorable. A second recession is unlikely but sequential momentum could soften. Indeed, leading indicators such as US ISM New Orders Index (leads Malaysia's exports by approximately four months), OECD leading indicator, LEI, ECRI leading indicator and China's PMI have come off from their respective highs in 1H10. In addition, the government's reiteration of its commitment to fiscal consolidation implies less support from public sector spending going forward. Nonetheless, it is not a hard-landing story that we have built in, but rather one of a more moderate pace of growth heading into 2H10 and 2011. The economy will continue to see support from global trade and relatively elevated commodity prices. We discuss Malaysia's three-legged growth model of trade, commodity and public sector spending below.
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