United States: A Tale of Two Tiers

David Greenlaw | New York

Over the past few months, the two-tiered nature of US economic activity has become increasingly apparent. The goods sector has displayed significant softness — primarily concentrated in the homebuilding and motor vehicle industries. Meanwhile, the service sector looks to be cruising along at a healthy growth clip. To be sure, the results of the Institute for Supply Management (ISM) surveys covering the manufacturing and service sectors in November highlighted the sharp divergence. However, there now appear to be indications of a near-term bottoming in motor vehicle assemblies as well as a possible moderation in the pace of decline in home construction.

The motor vehicle industry — accounting for about 3% of overall GDP — has certainly undergone a gut-wrenching correction over the course of 2006. In an attempt to improve long-run profitability, low margin fleet sales have been pared and legacy costs have been written down. The downsizing has been significant. From 2002 to 2005, domestic vehicle production averaged 12.1 million units annually — with very little variation around that pace (specifically, output was 12.3 in 2002, 12.1 in 2003, 12.0 in 2004 and 12.0 in 2005). Over the course of 2006, assemblies were cut to about an 11.0 million unit pace. Based on the Federal Reserve’s seasonally adjusted data, the downshift in vehicle production played out gradually over the course of this past year. Indeed, after troughing at 10.4 million units (annualized) in October, current assembly schedules point to sequential upticks in both November and December, followed by a flattening out in the first quarter of 2007.

Is such stabilization reasonable? We think it is. Our latest US economic forecast shows overall light vehicle sales (including imports) running near 16.1 million units in both 2007 and 2008. This represents a further slowing relative to the 16.5 million units sold in 2006 and the 16.8 average pace recorded during 2002–2005. Most importantly, current inventory levels appear to be in reasonably good shape. Indeed, at the end of November, stockpiles were 3.5% below last year and the lowest for that particular month in the past five years. So, with domestic production having been shaved by more than 1.0 million units relative to the 2002–2005 run rate and with sales likely to decline by a somewhat smaller amount — even after allowing for some pickup in imports — the industry appears to have already reached a production equilibrium. Thus, the powerful economic headwind associated with the downshift in motor vehicle production may now be behind us.

One other quirk involving the motor vehicle sector deserves mention. In 3Q, the statisticians at the Fed came up with a dramatically different estimate of seasonally adjusted motor vehicle output than seen in the GDP data. Specifically, the Fed’s IP figures showed a sharp decline in assemblies — enough to subtract 0.6 percentage point from GDP growth. Meanwhile, the GDP accounts showed motor vehicles adding 0.8 percentage point. While there is always some divergence between these two measures, due largely to differing seasonal adjustment factors, the gap evident in 3Q is unprecedented. We expect to see an offsetting swing in the respective measures in 4Q and have built this into our GDP estimate. However, the Fed’s data series is cleaner and certainly fits much better with the widespread indications of a significant pullback in vehicle production during 3Q. Down the road somewhere, we wouldn’t be at all surprised to see the Commerce Department revise its motor vehicle data in a manner that brings it into better alignment with the Fed series.

What about the other major identifiable headwind confronting the US economy — housing? As my colleague Dick Berner laid out in a recent analysis, while there have been some encouraging signs of late — in particular, a noticeable upturn in weekly mortgage application volume — it is still far too early to call a bottom (see “False Dawn for Housing Demand?” December 8, 2006). But, it does seem clear that progress is being made. The accompanying chart shows the NAR’s measure of housing affordability. The affordability gauge is a relatively simple metric that can be used to help value the housing market. It’s based on only three variables: home prices, mortgage rates and median household income. The higher the index the better — that is, a high reading implies high affordability and vice versa. Over the course of much of the past decade, affordability remained elevated despite skyrocketing home prices. Obviously, this was largely a reflection of declining mortgage rates. Only in the past year and a half did affordability start to show signs of becoming increasingly stretched as home prices continued to rise as mortgage rates bottomed out. By mid-2005, the affordability gauge was pointing to a fundamental misvaluation in the housing market. And the market now appears to be undergoing a price correction that will eventually restore a reasonable degree of affordability. Indeed, the figure shows historical data plotted through October with an extension of the series going forward based upon the following assumptions: (1) a 5% decline in home prices over the next year, (2) steady mortgage rates, and (3) a trend rate of growth in household incomes. In such a scenario, affordability is restored to an equilibrium level within a year or so.

Obviously, such an outcome does not necessarily mean that prices won’t go down by more than 5% in some markets. As seen in the figure, while affordability in the West (dominated by California) is consistently more stretched than for the nation as a whole, a 5% price drop would not be sufficient to restore the index to its 1995–2005 average. Indeed, certain regions of the country already appear to be experiencing significant price declines in response to severely stretched affordability. But this is all part of the adjustment process. As long as mortgage rates don’t rise too much, we expect the price correction nationwide to be roughly in line with that experienced in the 1990 episode. In that instance, real home prices, as measured by the OFHEO index, declined by about 6% over a 1-year timeframe.

What would such a price swing imply for the consumer? With the household sector’s holdings of residential real estate valued at a shade over $20 trillion as of end-3Q, a 5% decline in home prices would lead to about a $1 trillion loss of wealth. Applying a standard wealth effect of .04 (that is, a 4 cent impact on consumer spending for every dollar of change in wealth), implies a $40 billion hit to consumer spending in a static sense. This is significant, representing nearly 0.5 percentage point of consumer spending. However, it actually pales in comparison to the potential short-run impact associated with the recent plunge in gasoline prices. Through much of the spring and summer, the national average price of regular gasoline hovered around $3/gallon. Over the past few months, the price dipped to about $2.25/gallon. With gasoline and fuel oil accounting for 4% of overall consumer spending, such a swing in prices frees up roughly $90 billion of discretionary spending. In our view, this is one factor — in conjunction with generally stimulative financial conditions — that has helped to prevent the spillover of the housing market correction to the rest of the economy.

Of course, the sharp drop in homebuilding activity experienced during recent quarters has been a major direct hit to the overall economy. Indeed, our latest estimates suggest that Fed Chairman Bernanke was spot on when he indicated during a Q&A session following an October 4 speech that the decline in residential construction activity would shave about 1 percentage point from GDP growth during the second half of 2006. However, as the inventory of unsold new homes begins to respond to the cutback in new construction, the drag on the overall economy from reduced homebuilding should begin to ebb as we head toward mid-2007.

Setting the stage for 2007 growth. In sum, we appear to be at the end of a major correction in the motor vehicle sector and within a quarter or two of experiencing a deceleration in the pace of decline in residential construction activity. This should set the stage for the economy to resume growth at (or even a bit better than) trend in the second half of 2007.

United States: Inflation Uncertainty

Richard Berner | New York

Inflation appears to have peaked in September, and inflation risks seem to have moderated, as both inflation expectations and growth have cooled over the past few months. For example, year-over-year “core” inflation measured by the CPI has declined by 0.3% in the past two months to 2.6% in November, and measured by the Fed’s preferred gauge, the personal consumption price index (PCEPI), it probably declined to 2.2%. Surprising softness in a broad range of categories — motor vehicles, air fares, communication and apparel — yielded a flat core rate in November.

Adding to the good inflation news, longer-term inflation expectations calculated by the University of Michigan’s consumer canvass remain below their summer peaks, although they edged up to 3.1% in early December. And distant-forward (5-year, 5-year) inflation compensation has moved down by 25 basis points from summer levels. Together with slower growth, those factors prompted us to reduce slightly our baseline inflation forecast for 2007 to 2.4%, and to predict a steady monetary policy until late next year. Is that inflation forecast now too high?

It could be, but before jumping to that conclusion, it’s worth remembering that there’s still considerable uncertainty over inflation measurement and key inflation determinants, and thus about the outlook. That uncertainty will probably dominate the inflation outlook and thus the monetary policy debate in 2007. Some officials legitimately take comfort from today’s well-anchored inflation expectations. But as I see it, neither policymakers nor investors should take them for granted; today’s well-behaved readings could change and don’t guarantee that inflation will recede. The commitment of monetary policy and possible policy action to assure that outcome is the missing link. Thus the Fed’s policy bias may be slow to change.

There is, to start, uncertainty over the “right” measure of underlying or core inflation. The two popular measures of core inflation both moved up over 2006, but the core CPI accelerated by 60 bp but core inflation measured by the PCEPI rose by only 0.1%. The main culprit for the divergence: Shelter, which has twice the weight in the core CPI as in the PCEPI, took off with increased demand for apartments and a sympathetic response in the so-called owners’ equivalent rent category. As these and other factors fade, these two metrics are converging. In the three months ended in November, the core CPI rose at just a 1.6% rate, while the core PCEPI probably decelerated to 1.8%.

Nonetheless, these data may exaggerate the inflation downshift. We’re suspicious that some of November’s price softness may exaggerate reality or may not last. In particular, motor vehicle discounting may ebb with inventories of new cars and trucks back to desired levels. Moreover, while airlines may have passed on lower fuel costs to fares in recent months, load factors are high and anecdotal reports point to a recent rebound in fares. And the unusual weakness in the communications category this month largely reflected a sharp drop in the price of internet access services — perhaps tied to recent price slashing by a major provider.

What’s more, there’s much less certainty over how to measure key inflation determinants and the model that links them to inflation. What are those determinants? The workhorse “markup over cost” inflation model has proven increasingly less reliable, courtesy perhaps of good monetary policy, globalization, and changes in firm pricing behavior. Indeed my own analysis suggests that firms now price “to market,” setting prices based on conditions of demand and supply in global product markets.

Both models do include three key elements, however: A measure of inflation expectations, a gauge of slack in the economy, and factors that “pass through” to underlying inflation, like changes in energy or import prices. But it appears that the slack-inflation relationship has loosened over the past several years, and that the pass-through has also diminished. This flattening of the so-called “Phillips curve” means that as slack dwindles, inflation may not rise as much today as it did in the past. But it also means that the cost of bringing inflation down may have risen.

Or has it? The price to market model may help explain this phenomenon, as companies absorb costs, including currency swings more readily into margins. But lower and more stable inflation expectations may also have shifted the relationship rather than altered its slope, so that empirical analysis must consider all these factors. Indeed, recent studies show that inflation expectations may exert a “gravitational pull” on inflation so long as a credible monetary policy provides a “nominal anchor” for them (see Brian Sack and Joel Prakken, “Inflation Modeling,” Macroeconomic Advisers, December 13, 2006). The pricing dynamics of such models are consistent with my price-to-market hypothesis.

Operationally, however, our inability to measure economic slack and inflation expectations with any precision also adds to inflation uncertainty. Measures of slack in the economy, like the output gap, are unobserved, and the unemployment rate only measures slack in labor markets, not in product markets. Some fear that potential growth has recently shrunk by as much as 1 percentage point to 2½%. In my view, it has declined, but to about 3%. In any case, that issue is a key source of today’s inflation uncertainty among policymakers and investors alike.

Likewise, Fed Vice-Chairman Kohn recently noted that “the reliability and usefulness of the existing data [on inflation expectations] are less than we might like.” And “inflation compensation measures are ‘contaminated’ both by an inflation risk premium and by differences in liquidity between the markets for nominal and indexed Treasury securities…and give only a sense of where inflation is expected to go, not why it is going there.”

That statement highlights a risk in using market-based measures of inflation compensation as independent evidence on inflation expectations: Fed policies affect market prices, so breakeven inflation reflects the Fed’s own views. Thus, Vincent Reinhart, FOMC secretary, opined in 2003 “to rely exclusively on market prices to inform policy decisions is like looking in a mirror” (“Making Monetary Policy in an Uncertain World,” August 28, 2003).

But there is also a positive element to such market-based measures: They serve as barometers of the Fed’s commitment to keeping inflation both low and stable. Fed officials can look to such measures as one barometer of their commitment to assure the right outcome. But they are not the only such measures. Richmond Fed President Lacker worries that three years of inflation running above the Fed’s presumed comfort zone will allow inflation expectations to drift higher. In that context, the Fed’s tightening policy bias serves as a commitment to cap inflation, and a contingent signal for action if needed.

Given inflation uncertainty, inflation risks seem evenly balanced around our baseline outlook: A stumbling economy could reduce inflation faster than we think likely, while stronger growth that reduced product and labor-market slack would boost it. In the spirit of the holiday season, however, it’s worth noting that one admittedly uncertain metric puts inflation well above the Fed’s presumed “comfort zone:” PNC’s Christmas Price Index. According to the 22nd annual survey, the cost of the gifts in “The Twelve Days of Christmas” is $18,920 in 2006, a 3.1 percent increase over last year. Even so, I’m most certain that the Fed’s tolerance for higher inflation than today’s is limited.

Currencies: A Retrospective on 2006: A Cyclical Dollar Downturn

Stephen Jen | London

This is a time for reflection on 2006

I am saving my 2007 outlook for the first week of January. Instead of looking ahead, I think it is useful, at the end of the year, to take a moment to reflect on the year that has just gone by, and to evaluate my calls this year and draw lessons from how the currency markets behaved this year.

What I said at the beginning of the year

1. “The story for the dollar this year will be cyclical and closely linked with the developments in the US housing market.” I argued that the ‘trendy’ phase was over and for 2006, I saw a “gentle turn in the dollar in sync with a soft-landing in the US housing market. I also argued that the US current account deficit would reach an ‘inflection point’ in 2006, which should diffuse much of the angst about the dollar from a structural perspective.

2. “2006 will be the Year of the CNY. More flexibility and more meaningful appreciation of the Chinese currency are expected.” As the CNY appreciates, it will push all the Asian currencies stronger against the dollar. JPY will be the laggard in this bunch due to its very low yield … China will become the largest foreign reserve holder in the world later this year, surpassing Japan.

3. “The dollar’s movements this year will likely be asynchronous against various currencies.” “In contrast to the previous four years, the dollar’s movements are likely to be asynchronous against different currencies. In other words, the USD is likely to peak at different points in time against various currencies.

My good and bad calls this year

In my view, my call for a cyclical dollar correction centered on the US housing market has been broadly correct. I argued a year ago that EUR/USD was forming a bottom in the 1.17-1.18 range. I was also correct in expecting USD/AXJ, led by USD/CNY, to trade lower this year, with USD/JPY being the laggard due to the low yields in Japan. Importantly, my prediction that the US current account deficit would reach an inflection point this year also seems to be correct.

I was, however, wrong on several fronts. (1) I had underestimated the market’s support for EUR/USD and the ability of the Euroland economy (Germany in particular) to recover. (2) In contrast, I was too aggressive on USD/JPY this year, thinking that USD/JPY would go on being weighed down by positive real economic fundamentals, and that the relative low nominal yields would matter less over time. (3) I underestimated the scope for EUR/JPY to trade higher. Even though I proposed the ‘Global Funneling’ concept as an explanation for this upward structural drift in EUR/JPY, I did so quite late (August). (4) I had expected the three commodity currencies to depreciate against the dollar, as the global economy decelerated with the US, and because these currencies were already over-valued. Further, I had expected that the prospective unwinding of the JPY carry trades would weigh on these high yield commodity currencies.

Lessons from 2006

There are several key lessons from 2006 that will be important to keep in mind for 2007.

• Lesson 1. Financial globalization will remain a powerful driver of exchange rates. By financial globalization, I mean the sharp rise in cross-border capital flows, both private and official, in recent years. Trade balances and globalization of the goods markets are clearly important, but I believe that capital flows and financial globalization are even more important in dictating where exchange rates go.

First, it has been a global trend that ‘home biases’ have declined in most countries. This has made current account imbalances a much less powerful predictor for exchange rates.

Second, as virtually all countries are diversifying, it has been difficult to draw clear, definitive conclusions for currencies. As a result, investors have thus been forced to extrapolate from announcements made by a few central banks and countries that are unfriendly toward the US, such as Iran, North Korea and Venezuela. My view on this subject of central bank diversification is quite different from popular opinion in the market, but I concede that since the prevalent view can neither be proved nor disproved, comments and rumors will continue to fuel bouts of mini-attacks on the dollar, interrupted by sporadic surges in the dollar based on economic fundamentals.

Third, as the official reserves of several key central banks in the world exceed what are needed for liquidity purposes, many central banks will likely deploy the additional or new foreign reserves to investments that are higher-risk but with higher expected returns. This evolution from pure reserves to the ‘sovereign wealth funds’ has begun, and will have very significant implications for not only the currency markets but also bond and equity markets in the years ahead.

Fourth, in thinking about the fair values (FVs) of exchange rates, it is also important to consider a concept I proposed several years ago: Multiple Shadow Prices. The basic idea is that, while most fair value calculations, including ours, are based on real economic fundamentals, given the importance of global capital flows, a parallel concept is that some countries may have very different exchange rate FVs, from the perspective of capital markets.

• Lesson 2. Cash yield differentials will likely remain important. I have long resisted accepting that nominal cash yield differentials could be such the dominant driver for exchange rates. To me, over time, real economic fundamentals (such as productivity and the terms of trade) should be important and carry should not. How the currency markets have behaved in 2006 suggests otherwise, however.

First, cross-border asset holdings have grown drastically in recent years, the need to hedge should also have increased. Since hedging costs are dictated by nominal short-term interest rates, cash yield differentials may have become a more powerful driver than in the past.

Second, I have recently realized that the sensitivity of exchange rates to nominal cash interest rates may also have been due to the enhanced transparency of central banks in their communication strategy.

• Lesson 3. Don’t bet against the Fed. To me, the Fed has been the best forecaster of the US economy. At virtually all turning points since 2002, the Fed has been ahead of the market and made the correct call. I am not saying that the Fed does not make mistakes, but merely pointing out: (i) the remarkable level of confidence the Fed’s detractors have in this environment of uncertainty; and (ii) the recent superior track record of the Fed, compared to anyone else in the market.

• Lesson 4. Beijing to be more flexible in the years ahead. I believe that the single most important development in China this year has been the explosive growth in its trade surplus. There is no way around: (i) China’s additional reserves being converted into a ‘sovereign wealth fund’; and (ii) the rate of crawl of USD/CNY accelerating further.

• Lesson 5. Don’t underestimate any economy, even Euroland. Back in early 2005, Japan surprised many with its economic recovery, as did Germany a year later. The point here is that a lesson I have learned is not to dogmatically cling to preconceived notions: a structurally flawed Euroland can exhibit surprising resilience. The durability of the recovery we are witnessing is the next test for Euroland, but commentators (like myself) and investors should be open-minded about this.

Bottom line

Many of the key themes that have dominated this year will likely carry over to 2007. I will present my 2007 currency outlook in more detail early next year.

Global: Freer Trade Matters

Jeffrey Matsu | New York

Global trade linkages have deepened across all major regions in 2005, with global trade as a share of GDP expected to exceed $14 trillion, or 30% of world GDP, this year. From 1987 to 2005, global trade accounted for 36% of global GDP growth (at market exchange rates), more than double the 17% seen during the 1974 to 1986 period. According to IMF estimates, world trade volumes of goods and services will have grown 8.9% in 2006, well above the 7.5% longer-term growth trend and our call for 5% GDP growth this year. While technological advances contributed to a sharp reduction in transportation and telecommunications costs, thereby stimulating trade, it was a more inclusive trading system that generated tailwinds for economic growth and recovery. Developing countries are benefiting from this integration as well — the ratio of trade to GDP of least developed countries increased from 25% in 2000 to 30% in 2004, the latest year for which data are available. As a result, any move toward reduced openness could limit their potential for growth.

Pundits have argued that a mix of factors preordained the death of Doha — decision-making based on consensus in an increasingly disparate WTO membership, recalcitrance of developing countries represented by the G-20, and the more prominent role of bilateral and regional free trade agreements. Reluctance of the US and Europe to meaningfully liberalize their highly subsidized agricultural sectors has not helped either. Yet it is precisely those countries and regional blocs most exposed to the competitive pressures of globalization that have reaped the benefits of free trade in recent years. Between 2003 and 2005, average annual growth in the export of goods from ASEAN, Mercosur and the Andean Community exceeded that of the EU-25 and NAFTA (18%, 25% and 31%, respectively, versus 13%). While the former are dwarfed in absolute size by the latter, their export and import shares with the rest of the world are considerably higher. This is not to say that free trade alone fuels economic performance, as fiscal prudence and balance of payments are equally, if not more so, important, but it helps. GDP growth in the Mercosur is expected to remain above 4% this year and next, and our prognosis for the ASEAN-5 is equally strong with 5%+ growth projected through 2008. This contrasts with a deceleration of growth below 3% in NAFTA next year, and weaker growth in Europe as well.

If free trade is so beneficial for growth, then why have negotiators refused to compromise? Poor countries, led by Brazil, India and South Africa, have argued that as latecomers to a game created by and primarily for the rich, they are at a distinct disadvantage and hence should be expected to yield less ground. Yet inter-regional export diversification is most pronounced in Africa, the Middle East and Latin America, accounting for trade shares of 84%, 72% and 90%, respectively. Bilateral trade flows between China and Africa have more than tripled since 2002, and Africa’s net trade with China is now positive. Moreover, according to the World Bank, more than half of the costs associated with the exports of poor countries results from restrictions imposed by other poor countries. For example, the tariff structure imposed by India on textiles from neighboring countries such as Bangladesh and Sri Lanka effectively doubles or triples final product prices, heavily skewing the terms of trade. Roughly sixty percent of total customs duties collected on merchandise imports worldwide accrue to the developing world, based on data from the WTO.

Unfortunately, the explosion of bilateral and regional trade deals over the past several years has distracted from multilateral efforts, consuming limited political capital which will be needed if Doha is eventually to succeed. Asking politicians to repeatedly take the stand for trade liberalization, no matter how small or inconsequential the deal, is neither a smart nor sustainable strategy. Yet just about all 149 WTO members participate in at least one of the nearly 200 regional trade agreements currently in effect. Not only does this lead to inefficiencies for multinational companies who must devote more resources to understand the myriad of rules and regulations affecting their products, but it negatively impacts smaller or poorer countries that often do not possess the clout to extract favorable trade terms. To fix the mess they started, the US and Europe must exercise greater leadership in curbing preferential trade agreement (PTA) contagion if discipline is ever to be restored to the global trading system. This is particularly urgent given the enabling clause of the GATT, whereby trade amongst developing countries is unbound by Article 24 and the nondiscriminatory most-favored nation rights that apply to developed countries. For burgeoning economies such as China’s, which is expected to become the world’s second largest trader in 2007, the unrestrained ability to cherry-pick who gets what level of preferential tariff treatment is unlikely to nurture support for freer trade elsewhere in the world.

Acknowledging the redistributive nature of trade and implementing more robust mechanisms to support those who fall between the cracks will be necessary to stem the backlash against globalization. Deep-seated mistrust for further global integration has already been evidenced through a bevy of protectionist events ranging from the razor-thin passage of CAFTA in the US, rejection of the EU Constitution, and economic patriotism vis à vis the failed deals of Unocal/CNOOC and Dubai Ports World. China-bashing is also on the rise, with more than two dozen pieces of anti-China legislation circulating in the US Congress. Expanding trade adjustment assistance, in the form of worker retraining programs, enhanced educational opportunities and wage/health insurance schemes, could rebuild public support for freer trade in industrialized countries at relatively little costs. Estimates by the Institute for International Economics show that this would amount to an additional $3-12 billion annually in the US, a paltry sum compared to the $500 billion potential gain from further liberalization. Finally, multilateral organizations such as the World Bank are in a unique position to incentivize poor countries to open their markets through the administration of aid-for-trade programs that provide technical assistance and compensation for lost tariff revenues and special preferences.

To regain momentum on the global trade front, the world needs a policy jolt akin to the inaugural Asia-Pacific Economic Cooperation (APEC) summit held in November 1993. What worked as a catalyst for the Uruguay Round could work again for Doha. With roughly 40% of the world’s population, the 21-country trading bloc accounts for 57% of world GDP and 48% of world trade. As was the case then, the economic costs associated with the potential exclusion from an Asian Union or Free Trade Area of the Asia Pacific could bring Europe and other major holdouts back to the bargaining table. Aspirations of the Association of Southeast Asian Nations (ASEAN) to accelerate the creation of a single-market economy amongst its 10 members by 2015, and the proliferation of PTAs throughout the region, could also promote an outgrowth of competitive liberalization that reinvigorates Doha and puts global trade liberalization back on track.

Bilateral and other less-than-multilateral trade agreements are a poor substitute for a global deal, and lead down a dangerous road pot-holed with reciprocal barriers and other retaliatory measures. By further reducing market distortions such as tariffs, subsidies and quotas, Doha has the potential to reintroduce much needed discipline into trade negotiations that have increasingly favored one-off deals driven more by political rather than economic considerations. As part of a rules-based regime, developing countries are for once on a level playing field to have their voices heard. Threats from terrorism, escalating confrontations in the Middle East and heightened tensions with North Korea further underscore the imperatives to reform rogue states through economic integration rather than isolation. While laissez faire liberalism may not be the answer, neither is forfeiting on a more inclusive international rules-based trading system.

Global: The Term Premium - A Puzzle Inside a Riddle Wrapped in an Enigma

Sir Winston Churchill may well have been mistaken for a market strategist talking about the term premium rather than the foreign policy of the former Soviet Union. Bond yields and term premiums have stubbornly refused to come off their lows in spite of rising policy rates, strong growth and rising inflation.

The enigma: Why are bond yields so low? Will they stay low? Our proprietary model MS-FAYRE suggests that US 10-year Treasury yields should be at 5.5% — a whole 100 bps above their current levels (Fels and Pradhan, Fairy Tales of the US Bond Market, July 2006). If historical relationships are still valid, then the 17 increases in the fed funds rate and rising inflation expectations should have led 10-year rates higher. In this sense, 10-year rates have stayed too ‘low’, well below the fair value predicted by MS FAYRE and models of other researchers. The fact that the 10-year rate has stayed flat despite the tightening of monetary policy led ex Fed Chairman Greenspan to dub the enigma of low bond yields a “conundrum”.

A direct implication of the conundrum is that some factor(s) must be exerting downward pressure on the 10-year rate equal in magnitude to the upward pull from the factors included in fair value models.

Yield curves in the US and euro area have flattened dramatically since mid-2004, with the 10y-30y segment flattening more than the 2y-10y flattening would warrant. This is about the time that pension funds started buying long-dated bonds to cover the shortfall in duration from their liabilities. As the bonds with the highest duration at the end of the curve get richer, demand shifts to earlier points on the curve, with yields falling in inverse proportion to the duration of the bond.

Asian central banks have accumulated reserves far in excess of import requirements. Given the risk profile of these institutions, government securities in the US and Europe have been obvious destinations without much sensitivity to the price. Their sustained presence in bond markets is likely to have kept bond yields low (see Mutkin, Guzzo, Pradhan, Dec. 2006).

The impact of these factors also has implications for the estimates of term premiums from quantitative models.

The Riddle — Why has the term premium fallen? Will it stay low? The term premium estimated from the FAYRE model and from the model of Fed researchers Kim and Wright (2005) are highly correlated even though they use very different methodologies (see Fels and Pradhan, July 2006). These robust estimates suggest that the term premium has fallen since the 1980s as part of the Great Moderation, and has stayed close to zero during the 'conundrum' period. What accounts for such low term premiums, and will they continue to stay so low?

The potential solutions to the 'conundrum' may partly explain why the estimated term premium has been pushed so low. These recent forces have pushed bond yields lower than they would have been otherwise. What remains beyond the effect of the standard factors, i.e., the term premium, will be a much lower number than would have been the case.

However, the term premium riddle is not so easy to solve. The term premium can itself fall for fundamental reasons, taking yields lower with it. Thus, we are left with a ‘signal extraction’ problem: did yields fall because of special factors, or did they fall because of a decrease in the term premium? The answer probably is a bit of both! The term premium on the 10-year Treasury rate has been very well correlated with the MOVE index, an index of implied volatility on options on Treasuries. Intuitively, lower volatility in the market for Treasury securities implies investors will receive lower compensation for the reduced uncertainty, pushing term premiums and yields lower. The decline in volatility is at least part of the answer to the riddle of the low term premium. Finally, if interest rate volatility and the term premium are related, then volatility coming off its lows could mean a similar movement in the term premium and yields.

The Puzzle — Why has volatility fallen? Will it stay low? The correlation between interest rate volatility and the term premium leaves us with a final puzzle: What could have moved interest rate volatility to its current lows, and what could a trigger a rebound? Implied volatility on interest rate options tends to reflect periods of uncertainty regarding interest rate decisions, macroeconomic events or technical factors.

There are indications, however, that the current bout of low volatility can be attributed to a much-talked-about and less easily defined force — excess liquidity coupled with increasing integration of financial markets. The intuition behind excess liquidity can be extended to refer not just to the easy availability of credit and loose financial conditions, but also to the willingness to use these conditions to enter into leveraged positions seeking returns. This 'search for yield’ has led investors from asset class to asset class, bidding up prices and sustaining investor interest in spite of adverse news and events. The willingness to take on and maintain positions has made prices less pervious to shocks and news, i.e., it has lowered volatility across asset classes. As a result, spreads have compressed and implied volatility measures across interest rates, equities and currencies have moved to near-historic lows together.

However, if excess liquidity is reason enough for volatility to plunge, then its withdrawal should be reason for it to surge. Even though some measures of excess liquidity suggest a withdrawal of liquidity is at an advanced stage, no tell-tale surge in volatility has taken place as yet to confirm this link.

Excess liquidity is difficult to define and equally difficult to measure. Metrics that view excess liquidity via its price (i.e., interest rates) or its quantity (measures of money stock) may provide different answers. Quantity measures of excess narrow money in the G5 set of countries suggest that liquidity is no longer excessive (see Fels, Turn of the Liquidity Cycle, May 2006) . However, measures for broader definitions of money don't give the same answer, suggesting that financial conditions may still be easy. While our proprietary natural rate of interest models suggest that interest rates are at neutral in the euro area and above neutral in the US, this is definitely not the case in Japan or even China. Another proprietary measure of G-10 interest rates relative to their long-term mean (Stephen Jen, Charles St-Arnaud, Aug 2006) suggests that interest rates still have a distance to go to reach ‘normal’ levels. The upshot is that there are indications of a broad-based withdrawal of liquidity from the world economy, but this withdrawal has not yet become ubiquitous.

With US rates unlikely to push below neutral, and most other central banks looking to normalize interest rates (i.e., bring them in line with neutral rates), it seems but a matter of time before the withdrawal of excess liquidity shows up in most metrics, and most importantly in the availability of credit and the attitude of investors. The end of easy financial conditions in 2007 could put the puzzle together, sending volatility higher. Term premiums may follow, solving part of the riddle. Finally, the increase in term premiums would take yields higher, providing at least partial relief from the 'conundrum' of low bond yields.

Global: Dr. Jekyll and Mr. Bond

Joachim Fels | London

Jekyll and Hyde Following the ‘conundrum’ of low long-term yields during 2005 despite rising US short rates, global bond markets staged a (reverse) ‘Jekyll and Hyde’ performance during 2006, pretty much as I envisaged in my 2006 outlook piece a year ago (The Passing of the Batons, 8 December 2005). A sell-off during the first half of the year gave way to a powerful bond rally during the second half when the Fed paused and the signs for an economic slowdown in the US started to accumulate. As a consequence, the US 10-year Treasury yield now trades around 4.5%, only slightly higher than a year ago, but some 80 basis points below the peak of mid-2006. However, gazing into my crystal ball, I visualize a bearish scenario for the G3 bond markets in 2007, with yields moving back to, and possibly above, the temporary highs of last summer.

Three main drivers. In thinking about bond markets, I continue to focus on what I consider the three main medium-term drivers of yields: (1) the economic cycle and (2) inflation expectations, which together shape expectations of future central bank policy rates; as well as (3) the global liquidity cycle, which I suspect has been a key factor influencing the recently vanishing ‘term premium’ in bond yields (see also M. Pradhan, The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma, in this issue). Here are my assumptions and expectations for how each of these drivers will develop in 2007.

A global mid-cycle slowdown, but no recession. I assume that the global economy entered a mid-cycle slowdown during the second half of this year that will become more apparent during the first half of 2007. While this is qualitatively consistent with our global economic team’s forecast of a slowdown in global GDP growth from 5.0% this year to 4.3% (see Stephen Roach’s Global Transitions for details), I agree with Steve that the risks to this number are on the downside. Importantly, however, I assume that the slowdown won’t lead into recession, but will give way to a second leg of this expansion, albeit milder than the first leg in recent years, starting some time during the second half of 2007. A crucial assumption here is that the US slowdown remains temporary and largely bottled up in the housing sector, as our US economics team expects (see Richard Berner and David Greenlaw. It’s a Growth Recession, Not a Lasting Downturn, 11 December 2006). If so, at some stage next year, investors will likely revise significantly upwards their expectations for the path of the Fed funds rate in 2008 and beyond.

… with Europe disappointing and Japan surprising. Looking elsewhere, I envisage the euro economy disappointing the upbeat consensus expectations, but Japanese growth surprising on the upside in 2007. Japanese monetary policy is still very accommodative and the yen is super-competitive. Meanwhile, even though there may be a nascent pick-up in potential output growth in the euro area reflecting past corporate restructuring efforts and labour market reforms, cyclical growth is likely to be hit by the removal of monetary stimulus over the past year, fiscal tightening in Germany and Italy, and the trade-weighted appreciation of the euro. As a consequence, while I’m outright bearish on all the G3 bond markets, I do expect euro area bonds to outperform US Treasuries and JGBs in the sell-off, reversing their underperformance of the last six months or so.

Sticky inflation. While my view that this is a mid-cycle slowdown (though possibly a sharp one) rather than the onset of recession is in line with mainstream thinking among investors, my view on inflation isn’t. As I see it, market- and survey-based inflation expectations are too low and are likely to be revised up in the course of next year. The most likely trigger will be higher-than-expected actual inflation rates in the US and, possibly, Europe. One reason is that, in my view, the US economy is experiencing a structural slowdown in productivity growth, following a ten-year acceleration in trend productivity in response to the IT revolution, as US companies have now reaped most of the productivity-enhancing benefits of this revolution. Thus, labour costs per unit of output will rise more rapidly and potential output growth will fall. Moreover, the rise in the profit share to multi-year highs in the US and Europe suggests that some wage pressures are likely to emerge, supported by a growing consensus in society and political circles that workers should get a “fair” (read: higher) share of national income. Break-even inflation rates do not fully reflect these risks, and so I expect inflation linkers to outperform nominal bonds in 2007.

Tighter global liquidity, higher term premium. The experience of the last few years suggests that, even if short-rate expectations are revised up due to, say, higher inflation expectations or a better growth outlook, this need not translate into a rise in long-term bond yields, because this might be offset by a decline in the term premium. (Recall that the term premium is usually defined as the gap between the expected average short-term interest rates over the lifetime of a bond and the yield on that bond.) Most estimates suggest that the term premium has declined significantly in recent years (see J. Fels and M. Pradhan, Fairy Tales of the US Bond Market, 26 July 2006). While there are several competing explanations for the vanishing term premium, I continue to think that global excess liquidity, created by central banks around the world due to overly expansionary policies, is the main culprit.

While the Fed and the ECB are no longer expansionary on our measures, the Bank of Japan is still at the pump, and perhaps even more important, other Asian central banks along with their peers in the Middle East, Russia and Latin America are still flooding bond markets with excess liquidity as they recycle their growing external surpluses. Excess liquidity is unlikely to drop sharply in 2007, but it should become tighter at the margin. The Bank of Japan is likely to raise interest rates at least twice next year. Thus, G3 excess liquidity is likely to tighten further, at least until the Fed starts to cut interest rates. Moreover, with the global slowdown unfolding, Asian external surpluses will grow less rapidly or even shrink, and lower commodity and oil prices resulting from the slowdown would reduce producers’ revenues. Thus, Asian, Middle Eastern and Latin American central banks would have less fresh money to recycle into global bond markets, and so, somewhat paradoxically, weaker global growth would push bond yields higher.

Market outlook for 2007. I expect a combination of a global mid-cycle slowdown, re-emerging inflation concerns, and tighter global liquidity to push bond prices lower during 2007. In each of the G3 countries, I expect 10-year bond yields to climb towards and possibly break above their temporary highs reached in mid-2006 — 5.25% in the US, 4.15% in the euro area, and 2% in Japan. Investors should brace themselves for steeper yield curves and consider buying inflation protection. Euro area bonds should outperform US Treasuries in the bear market, as the upbeat expectations about European growth are likely to be disappointed. And with liquidity getting less plentiful and bond yields expected to rise significantly, risky assets will have a tough time repeating their stellar performance of recent years. Exit Dr. Jekyll, enter Mr. Hyde!

Global: From Globalization to Localization

Stephen Roach | New York

On one level, there seems to be no stopping the powerful forces of globalization. Not only has the world just completed four years of the strongest global growth since the early 1970s, but in 2006, cross-border trade as a share of world GDP pierced the 30% threshold for the first time ever -- almost three times the portion prevailing during the last global boom over 30 years ago. What a great testament to the stunning successes of globalization!

On another level, however, there are increasingly disquieting signs. That’s because of a striking asymmetry in the benefits of globalization. While living standards have improved in many segments of the developing world, a new set of pressures is bearing down on the rich countries of the developed world. Most notably, an extraordinary squeeze on labor incomes has occurred in the industrial world -- an outcome that challenges the fundamental premises of the “win-win” models of globalization.

It is a great theory -- but it’s not working as advertised. The first win -- that going to the developing world -- is hard to dispute. China has led the way, with more than a quadrupling of its per capita GDP since the early 1990s. Other developing countries have lagged the Chinese experience but have still made considerable progress in boosting living standards.

The problem lies with the second win -- the supposed benefits accruing to the rich countries of the developed world. And that’s where the going has gotten especially tough. In recent years, the benefits of the second win have accrued primarily to the owners of capital at the expense of the providers of labor. At work is a powerful asymmetry in the impacts of globalization and global competition on the world’s major industrial economies -- namely, record highs in the returns accruing to capital and record lows in the rewards going to labor. The global labor arbitrage has put unrelenting pressure on employment and real wages in the high-cost developed world -- resulting in a compression of the labor income share down to a record low of 53.7% of industrial world national income in mid-2006. With labor costs easily accounting for the largest portion of business expenses, this has proved to be a veritable bonanza for the return to capital -- pushing the profits share of national income in the major countries of the industrial world to historical highs of 15.6% in 2Q06.

This asymmetry in the second win is not without very important consequences. In days of yore -- when labor and its organized unions actually had bargaining power -- the current squeeze on labor income in the developed world would have undoubtedly resulted in some form of a “worker backlash.” In today’s increasingly globalized world, however, workers have no such power. But their elected political representatives most certainly do. And there can be no mistaking the important shift that has recently occurred in the political alignment of the industrial world -- with the majority shifting from the pro-capital right to the pro-labor left. Not only is that the case in the United States, but such a tendency is also evident in Germany, France, Italy, Spain, Japan, and possibly even Australia.

The stunning results of the recent mid-term elections in the US could well be the canary in this coalmine. A newly-elected Democratic Congress is about to find itself center stage in the battle between capital and labor. The old Congress was quite transparent as to where it was headed in this regard -- having introduced, by our count, 27 separate pieces of legislation since early 2005 that would impose some type of punitive actions on trade with China. The new Congress could go further -- not just on the trade frictions front but also in embracing additional elements of a pro-labor agenda. In fact, newly elected Democratic leaders already have promised immediate passage of the first increase in the minimum wage in ten years. In my view, these are just the early warning signs of a US Congress that is likely to be far more sympathetic to the plight of labor than it was in the past.

Nor is America alone in tilting to the pro-labor left. In France, the ascendancy of Ségolène Royal offers a modern-day mix of pro-labor politics with a protectionist bias. Italy’s Prodi is also pro-labor, and in Spain, Zapatero is certainly more sympathetic to the plight of labor than Aznar was. In Germany, Merkel has tilted increasingly toward labor after she nearly lost the election running on a pro-market reform agenda. The new Abe government in Japan has teamed up with the center right in support of the “second chance society” -- attempting to make certain that the victims in the rough and tumble arena of global competition are given the opportunity to come back. And in Australia, Kevin Rudd, the newly anointed opposition leader, seems set to center his platform on the struggle of the average worker.

I am not heralding the demise of globalization. What I suspect is that a partial backtracking is probably now at hand, as a leftward tilt of the body politic in the industrial world voices a strong protest over the extraordinary disparity that has opened up between the returns to capital and the rewards of labor. The extent of any backtracking is a verdict that lies in the hands of the politicians -- specifically, how far they are willing to go in legislating an effort to narrow this disparity.

As the self-interests of nation-states become increasingly prominent, the pendulum of political power should swing from globalization to “localization.” That would imply very different characteristics to the macro climate. The most obvious -- wages could go up and corporate profits could come under pressure. But it also seems reasonable to expect pro-labor politicians to direct regulatory scrutiny at excess returns on capital -- focusing, in particular, on the perceptions of excess returns in financial markets (i.e., hedge funds and private equity) as well as on the inequities of rewards at the upper end of the income distribution (i.e., tax cuts for wealthy citizens and the excesses of executive compensation). Moreover, localization taken to its extreme could also spell heightened risks of protectionism -- especially if the global economy slows and unemployment starts to rise in 2007, as we anticipate. Under those circumstances, inflation could accelerate, leading to higher interest rates, greater volatility in financial markets, and a potentially vicious unwinding of an over-extended credit cycle. And, of course, the protectionist ramifications of localization could prove equally challenging for the beneficiaries of globalization’s first win -- dynamic new companies in the developing world and the employment growth they generate.

Don’t confuse prognosis with advocacy. Many of these potential developments, especially a drift toward protectionism, are without any redeeming merit, in my view. But this is what happens when trends go to extremes. In free-market systems, the pendulum of economic power then invariably swings the other way. An era of localization will undoubtedly have more frictions than the unfettered strain of capitalism and globalization that has been so dominant over the past decade. The big question, in my view, pertains mainly to degree -- how far the pendulum swings from globalization to localization. The answer rests with the body politic. The repercussions lie in economics and financial markets.

Morgan Stanley - India: Beyond the Cyclical Boom

Unusually strong growth cycle. India has achieved strong economic growth of 8.2% over the past three years versus 6.2% in the preceding ten years. This compares with average economic growth of 10.3% for China and 5.3% for Emerging ASEAN countries in the past three years. Although we believe that some acceleration is warranted due to structural factors, the greater part of growth has been a result of the sharp rise in capital flows in response to an increase in the global risk appetite. The global liquidity spillover into India has allowed the government to pursue relatively loose monetary and fiscal policies, which have supported the acceleration in cyclical growth.

Structural story – an interplay of three macro factors. The interplay of three key macro factors – demographics, reforms and globalization – justifies a gradual speeding up in India’s pace of growth. India’s age dependency has fallen (the share of the working population in the total has risen), from 64% in 2000 to 59.6% in 2005, and is likely to continue to drop, to 55% by 2010 (according to United Nations’ forecasts). The government’s implementation of gradual but progressive reforms has improved the utilization of the working-age population, a key resource. Finally, a backdrop of strong globalization has enabled growth in job opportunities to accelerate. India’s exports are expected to rise to 21% of GDP as of 2006 from 12.6% as of 2000 (based on our estimates).

Cyclical story – facilitated by low global real rates. We believe that India has witnessed an unusually loose monetary policy over the past few years. The genesis of this has been the large capital inflows into India (and emerging markets in general). Cumulatively, over the past three years India has received capital flows of US$72 billion versus US$28 billion in the preceding three years. Low real interest rates globally and the consequent rise in risk appetite have driven this disproportionate increase in capital inflows into India.

With a weak supply-side response, India’s absorption of liquidity for investment has been less than optimal, resulting in excess liquidity. Over the past five years, households and the government have lapped up this liquidity, increasing India’s debt-to-GDP ratio by 26 percentage points, which has supported the acceleration in GDP growth. This compares with increases in the debt-to-GDP ratios of the US and China of 25 and 8 percentage points, respectively, during this period. This debt has, in turn, been used either to bolster consumption or to fuel asset prices, and has boosted growth beyond sustainable levels, in our view.

Persistent acceleration in growth raises risk of sharp contraction. If the growth acceleration trend is sustained by household and government borrowing at a time when corporate credit demand remains strong on account of capital spending, this could raise the risk of a steeper deceleration in growth. A trigger could be one of the following macro challenges:

Inflation pressure:With domestic demand (as reflected in strong credit growth) remaining strong, the central bank, the Reserve Bank of India (RBI), has been especially concerned about potential inflationary pressure. Headline wholesale price inflation (WPI) has reaccelerated to 5.3%, close to the RBI’s maximum tolerance level of 5-5.5%. Indeed, we believe the pressure on headline WPI will intensify as a result of increases in global commodity prices (other than oil) in the past few months.

Current account deficit:We have argued for a while that, in an open economy, if aggregate demand is higher than supply (reflecting a slower pace of domestic capacity creation), this contributes to a current account deficit as well as inflation. The current account balance turned to a deficit of US$6.1 billion (3% of GDP, annualized) during the quarter ended (QE) June 2006 from a surplus of US$1.8 billion in QE March 2006, driven by an all-time high trade deficit.

Stretched banking sector balance sheet:The gap between credit and deposit growth has been a key concern. Although credit growth has currently moderated to 29% from the peak of 33% in June 2006, it remains significantly higher than deposit growth of 21%. The trailing one-year incremental credit-deposit ratio is also very high, at over 90%. With the banking sector’s holding of government-approved securities (largely government bonds) already at 29.6% (close to the statutory minimum of 25%), there is little scope for banks to continue with the current high credit disbursement rate.

Credit quality: In addition to the strong growth in credit, the quality of credit being disbursed is causing concern. Banks have not only been lending more to riskier segments but have also been mis-pricing the credit. The RBI is clearly worried about the strong credit growth in the retail and real estate sectors. Although the RBI has initiated administrative measures to reduce the bias towards funding consumption and less productive sectors, there has not been a meaningful correction in this trend so far.

Property market euphoria:As discussed above, excess liquidity without an adequate supply response in the form of absorption of investments is resulting in higher asset prices. For property, the less supportive regulatory framework and the government’s inadequate and slow response to the need to create urban infrastructure have resulted in weak growth in property supply. As a consequence, property prices have risen by 100-300% in major cities in the past two years.

Global developments and re-pricing of risk:We believe the loose monetary and fiscal policies have supported a large increase in debt to GDP, which in turn has contributed to a spike in growth rates above sustainable levels. This rise in debt to GDP, without a commensurate increase in market-driven interest rates, has been due to large inflows of foreign capital, particularly portfolio equity flows (driven by a growing global risk appetite). Without these large capital inflows, real interest rates would have been higher and growth rates lower. We believe that any slowdown (not necessarily outflow) in capital inflows due to a change in the global environment could result in a disruptive rise in interest rates.

Our base-case forecast remains a soft landing. We expect growth to soft-land over the next four quarters to around 7%, driven by the lagged impact on credit growth of higher real rates and the central bank’s administrative measures. In the event of growth surprising on the upside, we think the risks of a sharp spike up in the cost of capital and an aggressive landing of the growth cycle would rise sharply. In our view, the government needs to implement measures to stimulate the supply-side response by investing in infrastructure, implementing labor reforms, improving the management of government finances and strengthening the administrative framework

Market View

We are likely to see some mid-cap out-performance, particularly once the January results give local investors an idea of the story for FY08. Growth expectations are currently around 15 per cent for FY08 on the previous year. However, in the mid-cap space this may be far higher. FIIs may also start to approach saturation of investible limits (due to foreign investment limits) in the large-cap space, which will lead to filtering down into more mid-cap names.

The risk to this situation is the 1 lakh crore IPO pipeline, which may absorb some of the FII demand and deflect from a focus on mid-caps. Additionally, the liquidity issues in mid-caps continue to be an issue for large investors. Finally, in a market like India, momentum tends to take hold at times and we may see further blow-out in large-cap premiums before we see mean reversion take place. If one were to step out from the current trend favouring large-caps and set the vision further, mid-caps represent the opportunity in that space.

OptiMix

Indeed, it seems quite logical that if the world's economies are increasingly intertwined and interdependent they will become less dependent on the United States. From a structural perspective we even feel that fundamental long-term strategies should increasingly be adapted to this inevitable trend. Of course, the extent to which the rest of the world's economies "decouple" from the United States will depend on how much they are "desynchronised" from the US economic cycle and on other specific factors that are endogenous to the various pieces of the global macroeconomic puzzle. No doubt that emerging Asia is still the key piece to this puzzle. This currently seems to be the main concern of market observers.

BNP Paribas Asset Management

Emerging markets (EM) has historically been vulnerable to deteriorating economic and financial conditions in the United States and other developed countries. Slower growth, tighter liquidity, and heightened risk aversion in mature markets generally mean lower commodity prices, less capital flows, and higher interest rates for EM borrowers — conditions that helped produce some spectacular financial crises in the past dozen years. Not a pretty picture, and one that begs the question of what lies around the corner.

Given this backdrop, it is interesting that 2007 growth estimates for emerging market economies continue to be robust, suggesting a potential divergence this time for EM. Certainly the nature of the slowdown (hard vs. soft) in the US is critical to the performance of the EM economies and will shape expectations for EM growth and the performance of the asset class. But fundamental, endogenous changes in the emerging countries suggest EM is far better equipped to deal with a G-3 slowdown in the current cycle than in the past.

PIMCO bonds Emerging Markets Watch

The on-screen multiplier effect

Three leading multiplex operators — Shringar Cinemas, PVR and Inox Leisure — have entered the listed space over the past two years. The promise of a superior experience relative to other entertainment options; the ability to charge higher admission rates than single-screen theatres; rapid expansion plans; and the onset of a "new and improved" Indian film industry that focuses on content, were factors that helped these companies trade at a premium valuation, post-listing, along the lines of retailing majors.

Post the correction in mid-caps, the stocks of Shringar Cinemas and PVR are now trading at levels closer to their offer price, even as Inox Leisure has fallen significantly from its earlier high.

While valuations have corrected, they remain on the high side. Although the demand for multiplexes from the cinema-going public shows no signs of weakening, problems in execution of expansion plans, coupled with the high risks associated with the business, could temper valuations. We analyse the performance of multiplexes in the post-offer period and provide an outlook for the stocks in the sector.

Robust revenue growth

Multiplex operators have recorded strong growth in revenues in the range of 40-60 per cent in the first half of FY-07, on the back of new multiplex additions. It has also been an exceptionally good year for the Indian film industry, which saw the release of a slew of successful films. High occupancy rates have persisted, allowing theatres to hike rates in the first few weeks of a film's release. Profit growth has outpaced sales growth, as overheads such as personnel and maintenance costs have been spread over a larger base.

The robust performance cannot eclipse the risk of sudden knocks in performance if the content suffers. Strong inflows from box office collections have, however, so far reduced the impact of a slower-than-expected rollout of theatre chains.

Problems in execution

The market has been factoring in a multi-fold expansion in properties across theatre chains. However, delays in receiving Government approvals and handover of properties from developers have slowed down the roll-out of theatres. A large portion of offer proceeds remain unutilised for most players, although this has not stopped Shringar Cinemas from raising foreign convertible debt of about Rs 90 crore to fund its expansion plans.

The stated expansion plans across the three contenders continue to be ambitious; companies expect to double and triple the number of screens they operate over the next two to three years. Screen additions are likely to bunch up in some quarters, which could skew the quarterly performance picture in a manner similar to what is being witnessed in the retail industry.

PVR appears to have managed a faster rollout than its peers and now appears to be fairly ahead of Inox Leisure when it comes to screen presence. This could be why it continues to trade at a premium to the other players.

Tussle with distributors

Scale is becoming increasingly important for multiplex operators. While a good box-office year has had cash registers ringing, distributors are not too happy with exhibitors walking away with a greater share of the profits. Multiplexes account for barely 5 per cent of the total screens in India but are estimated to rake in 30-40 per cent of box-office revenues every year, thanks to their ability to charge higher ticket rates.

Big banner productions such as Fanaa, Dhoom-2 and Baabul have had distributors demanding more favourable terms in the revenue-sharing agreements. Those who have succumbed to their pressure have seen pressure on margins. The distributor's share is one of the more significant expenses borne by operators, accounting for more than 20 per cent of revenues. Inox Leisure, for instance, has seen a rise of 700 basis points in distributor's share in the first half of FY-07.

Such instances are likely to crop up till multiplexes gain scale; operators now see merit in consolidating their presence in certain distributor territories to improve their bargaining power with distributors. They are also getting into distribution themselves to ensure supply of content for their exhibition business.

Stock view

Given that expansion plans were at an early stage, we had maintained that it would be difficult to pick one of the three as a superior exposure and had earlier recommended holding at least two of the three stocks. We remain positive on the sector and maintain our stance. Despite execution problems, we believe that the ramp up in revenues and earnings would be significant.

Among the three players, PVR is more expensively valued. Its larger scale and better execution capabilities appears to drive its premium valuation. Its foray into co-production for two films with Aamir Khan Productions, due for release in 2007, also appears promising. Higher share of theatres that carry tax benefits could also help scale up margins. However, given the stiff valuation, tolerance to poor quarterly performance would be low. Shareholders can hold the stock and investors can consider accumulation on declines.

While Inox Leisure is relatively more attractive, concerns stem from the steep decline in margins it has witnessed recently, on account of rising payout of entertainment tax and distributors' share. Inox has enjoyed higher-than-average operating margins thanks to its operating from locations that are exempt from tax. Sustaining this advantage might prove difficult. Retain holdings of the stock.

Shringar Cinemas' performance appears to be turning the corner, reversing losses in the first two quarters. Additional screens could result in a substantial improvement in revenues and earnings. Shringar's long experience in the distribution business will also be to its advantage once it gains scale. Execution, however, continues to be an issue as the company has been slow to roll out properties. Investors with an appetite for risk can consider exposure in the stock.

Thirumalai Chemicals: Hold

Investors can retain their exposures in Thirumalai Chemicals. Valuations appear to be moderate with the stock trading at about six times its trailing twelve-month earnings. However, volatility in prices of raw materials and finished products is a dampener. Growth in key user industries is likely to translate into higher volumes for its anhydride businesses.

Business

Thirumalai Chemicals occupies a dominant position in the phthalic anhydride (PAN) business from which it derives about 72 per cent of its revenue. The company is also the largest manufacturer of maleic anhydride (MAN). Medium-term threats from peers appear muted given their financially weak position.

The threat from imports is also not imminent, as they constitute only a minuscule portion of domestic consumption. International prices, however, play a key role in determining domestic prices of PAN and MAN.

The company occupies a dominant position in its key products. The company also manufactures food acids and phthalate esters, which together contribute about 7 per cent of its revenue.

Growth

Paints, plastics, dyes and pigments industries are among the larger consumers of PAN. Consumption of MAN is driven mainly by the unsaturated polyester resins industry. Growth in the user industries has contributed to higher PAN offtake which, of late, has been in double digits.

While the real-estate boom and the government's focus on the textile industry are likely to help in sustaining this growth for PAN, higher offtake for MAN is likely to come from the automobile industry. With its plants operating substantially below installed capacity, the company is poised to tap growth opportunities in these businesses.

Margin pressure to remain

The company operates in a raw material intensive business with input costs constituting about 80 per cent of operating expenditure.

A surge in prices of inputs and an inability to pass on the entire impact to its customers led to the company facing margin pressure in FY-06. While domestic prices of PAN and MAN have stabilised, that of the key raw materials continue to fluctuate.

Thirumalai Chemicals is expected to face margin pressure with prices of crude oil hovering around $60 a barrel. Prices of orthoxylene, which constitutes about 80 per cent of its input costs, are closely linked to that of crude oil.

International prices of benzene, which were on a decline since the beginning of October, continues to be about 60 per cent higher compared to a year earlier.

With an intention to reduce volatility of margins and to increase operating levels, the company has entered into contracts with customers for supply of PAN on a formula basis.

Backed by better operating margins and higher asset turnover ratios the company, unlike its peers, has been able to withstand the vicissitudes of the commodity cycle.

Contract tie-ups are likely to translate into lower inventory levels and rein in the sluggish cash flows, which has been a concern.

Thomas Cook: Hold

There has been a lot of buzz around the Thomas Cook (TC) stock in recent times. Since its acquisition by Dubai Financial early on this calendar, the company has been busy putting together a series of buys to strengthen its position in the financial services and the travel and tourism-related businesses. At the current price of about Rs 520, the stock trades at about 33 times its trailing four-quarter earnings per share.

Though that looks expensive, the street appears to be pricing in most of the positives that will flow from the recent acquisitions once they take full effect.

We, however, are circumspect at this juncture, as equity expansion and/or debt raising plans to fund inorganic growth may be around the corner. In our view, shareholders can retain their holdings of the stock.

Thomas Cook used to follow a November-October fiscal; from next year, the calendar year will represent its financial year. The ongoing fiscal thus would be of 14 months long (November 2005-December 2006).

The first acquisition was that of LKP Forex, a subsidiary of LKP Merchant Financing. LKP's strength in the foreign exchange business will complement TC's business in the same space, in which it is an established player.

The merger, through a share-swap route, is likely to be completed any time now. TC went on to acquire the inbound travel business of Thomas Cook Thailand for Rs 15 crore.

Earlier this month, TC announced the acquisition of Travel Corporation of India (TCI) in an all-cash transaction of about Rs 180 crore; with its entire shareholding to be bought out, the latter will become a 100-per cent subsidiary. TC is also picking up a 76-per cent stake in the visa facilitation services business of TT Enterprises for a cash consideration of Rs 17 crore.

Business impact

Clearly, all the acquisitions possess synergies with the existing operations of TC. While the LKP merger will lend greater scale to the financial services business and provide cross-sell opportunities on account of geographical reach, the TCI acquisition will give fillip to the inbound tourism business, an area in which TC does not have a significant presence.

The stake pick-up in TT Enterprises should strengthen TC's presence in a niche area.

On the business front, for the 12-month period ended October, there has been significant traction on the revenues front, which logged a 30 per cent growth at about Rs 170 crore. But a faster rise in staff costs and other expenditure led to a muted performance in operating profits. Margins on the financial services business continue to be healthy at over 50 per cent; on the travel-related services business, margins dropped a few percentage points.

While the impact of the amalgamation and the acquisitions is likely to be earnings accretive, a tighter control on costs could propel earnings significantly.

We would watch out for any expansion in TC's equity — subsequent to the LKP amalgamation — to fund its inorganic growth plans. The mode of fund raising is yet to be firmed up; TC could also raise debt, though this would be reflected in the form of higher interest costs and partially offset the synergistic benefits of the acquisitions that would flow into the bottomline.

Valuation

TC has always quoted at a rich valuation of 25 times the earnings, even in years when its earnings hit a trough on account of extraneous circumstances (as in 2002 and 2003). Though earnings did move up sharply in 2004 and plateaued subsequently, we believe the market's optimism about the company's performance, and not unjustifiably so, is what is driving the price.

Even as TC has made the right moves by stepping on the gas, it will be its delivery on the earnings front that would merit close attention. Stay invested.

Aztecsoft: Buy

Investors with a medium-term perspective can consider an exposure in the Aztecsoft stock. We are upgrading our `hold' recommendation made in early September to a `buy' based on our bullish view on the core business of outsourced product development (OPD) and testing market.

The robust second quarter performance, along with strong client additions after a disappointing first quarter, has improved the financial picture.

However, this stock will be appropriate only for investors willing to look beyond the next two quarters (December 2006 and March 2007), as there may be some turbulence in the stock linked to two factors: One, Dendrite International Inc, one of the large customers of Aztec contributing 10 per cent of revenues, has exercised the option of acquiring the offshore development centre in Bangalore built and operated by Aztec.

The transfer to Dendrite will be effective January 1, 2007, which will be reflected in Aztec's financials in the fourth quarter of 2006-07. Two, the impact of rupee appreciation and aggressive employee addition in the latest quarter lowering utilisation in this specialised activity may affect financials in the short run. As the medium-term picture remains robust, we recommend that investors accumulate the stock on any weakness linked to these events.

At the current market price, the stock trades at a price-earnings multiple of 16 times its likely per-share earnings for 2006-07. In the OPD space, companies operate with early-stage outfits backed by venture capital funding; any slowdown in technology or venture capital funding can affect its financials.

Robust second quarter

After the disappointing performance in the first quarter of 2006-07, the company has bounced back with a strong 14.2 per cent sequential growth in consolidated revenues and 23.6 per cent growth in post-tax earnings. While the operating profit margin improved by over two percentage points to 23 per cent, the net profit margin also perked up by one percentage point to 17 per cent. Aztec's operating margin is relatively higher than some of its mid-cap peers on account of its higher offshore contribution (at 85 per cent) and lower operating expenses.

Client addition has been quite strong in recent quarters. The company has added 13 clients in the second quarter taking the total active client count to 83. And the latest additions include established wireless players and ones from the software as a service domain. After expanding its set of offerings in the OPD space, Aztec recently entered two new technology segments: Wireless and networking technologies, and embedded and device technologies. Apart from this, over the past year, the company has also been making investments in newer technology services such as Web 2.0 and Software as a service, broadbasing its overall client list.

It was also a quarter in which Aztec made a significant ramp-up in the employee count, adding 525 employees vis-à-vis 113 added in the first quarter.

A chunk of its revenues (53 per cent) continues to accrue from the top five clients. And this remains a cause for concern in the medium term.

If the demand environment remains strong over the next year, Aztec is likely to reap the benefits of billing rate upsides in its existing client accounts. As the company is also actively scouting for acquisitions, any specialised small-size acquisition at reasonable valuation may prove to be a positive trigger for the stock.

Emami: Hold

With over a three-fold rise in stock price since its public offer in March 2005, Emami has outperformed several of its larger peers in the FMCG space over this period. The company has managed a strong pace of growth in its topline and earnings over the past year with successful launches in the personal-care space. After the recent re-rating, the stock's valuation levels are stiff though in line with well-established competitors such as Marico Industries and Godrej Consumer.

Emami would remain among the riskier FMCG stocks because of the company's small size, which makes it more vulnerable to competitive pressures; the low liquidity in the stock is another issue. However, investors can hold the stock for now as there is scope for a significant ramp up in earnings in the coming quarters and potential for higher growth on a small base.

Reaching out

With brands such as Boroplus, Navratna oil, Sona Chandi Chyawanprash, Menthoplus balm and the recently launched Fair & Handsome, Emami occupies lucrative niche segments in the FMCG market (such as cooling hair oils, antiseptic creams, prickly heat powder and pain relief). Emami's focus is on aspirational categories such as personal care, health and grooming, all of which are now seeing strong growth momentum. Value growth in most of these categories over the past two years has outpaced volume expansion — a sign of the pricing power of the players.

The company is leveraging its Ayurvedic origins to foray into OTC (over-the-counter) and beauty products — again two high-growth segments. The company also has a good distribution network (2,200 distributors directly covering 3.8-lakh retail outlets), with extensive penetration into small towns and the rural areas. It is, thus, well positioned to exploit the expanding rural offtake of FMCG products (in 2006, the rural demand for FMCGs has outpaced that from the urban areas).

Finally, a significant presence for Emami's brands in the SAARC region and West Asia, helps it leverage on growth opportunities there. These factors have translated into accelerated growth in the company's topline and earnings over the past two years. The company followed up a 37.6-per cent growth in its topline in 2005-06, with a further 34.9 per cent growth in the six months ended September 2006. Net profits expanded by 67 per cent in 2005-06 and by 19 per cent in the first half of 2006-07.

The flip side

Despite the high growth rates and the focus on lucrative segments, Emami's relatively small size (revenues of Rs 300 crore in FY-06) exposes it to relatively high risks. Though the niche strategy and its distribution reach into smaller towns have so far insulated the company, to some extent, from competitive pressures, this could change. Apart from large players such as Dabur and Marico, several local brands are also trying to expand their presence in the personal care, health and beauty segments.

Several mid-size pharma companies have aggressive plans for OTC product rollouts, which would be pitted against Emami's brands. Intensifying competition could call for higher investments in advertising and promotions by Emami.

However, with adspend already accounting for over 20 per cent of sales, the company already spends substantially more on promotions than other listed FMCG companies (10-15 per cent).

Higher outlays on adspend could, thus, have a significant impact on Emami's operating margins, and leave it with a lower cushion to handle inflation in input costs.

Having exclusively adopted the celebrity endorsement route for its brands, the burgeoning adspends could continue to be a problem area for the company.

The company's ability to sustain the current pace of growth, as the profit and revenue base expand, is thus subject to some uncertainty.

For investors, the relatively low floating stock (promoters hold 88.2 per cent of the stock and institutions another 7.08 per cent) is an additional risk to factor in, as it makes for thin trading volumes on occasion and could magnify the downside in the event of a decline in stock price.

However, investors can hold on to the stock for now. Because of a seasonal business, Emami typically registers the bulk of its earnings in the second half of the year.

This, combined with the proposed merger of the group's distribution and marketing arm which is likely to bolster overall margins, suggests a potential for significant ramp-up in earnings in the coming quarters.

Patel Engineering: Buy

Strong presence in high-end infrastructure segments, superior operating profit margins and healthy order book augur well for the earnings growth of Patel Engineering (Patel). Investment in the stock can be considered with a two- to three-year perspective. At the current price, the stock trades at 15 times its expected earnings for FY08 and is at a discount to peers.

Patel has the advantage of a favourable project mix that contribute higher margins than typical construction projects. The company's revenue stream is derived predominantly from hydro power projects followed by irrigation and micro tunnelling, all of which enjoy margins of above 10 per cent with the last-named yielding as high as 20 per cent. This has resulted in Patel's operating and net margins being superior to a number of players in the infrastructure space.

The company's present order book at Rs 4,900 crore (6 times FY06 revenues) is skewed in favour of hydropower projects (50 per cent). This, coupled with increase in micro tunnelling projects, promises sustained margins. Acquisitions in the US and Europe have helped the company equip itself with superior technology that gives an edge over local competitors. Micro tunnelling, for instance, allows boring without trenches for laying water pipes and telecommunication wires. Amidst intense competition from established players such as IVRCL Infrastructures and Nagarjuna Construction, Patel has made its presence felt in the irrigation space. About 30 per cent of the current order book comes from irrigation. The company has received a number of orders in Andhra Pradesh, which is among the few states that have been actively investing in irrigation projects. These contracts will qualify the company to bid for more projects in this space. Patel has recently forayed into annuity road projects. Being a late entrant, it may face competition from established players. The debt-equity ratio of the company is slightly higher to peers. Profits, however, adequately cover the interest costs. Any slowdown in hydro power-related policy initiatives by the Government is likely to affect earnings.