Nordics: Sweet Dreams or Nightmare?

Thomas Gade | London

Strong growth and substantial risks
The Nordic economies (Denmark, Finland, Norway and Sweden) continued to pace ahead during 2006. On aggregate, we expect the Nordic region to expand by a staggering 4.2% this year, slowing to 2.9% in 2007 and further to 2.4% in 2008. Despite variations within the Nordic economies, growth in the Nordic region remains above that of the euro area on our forecasts. The Nordic economies in general have benefited from high productivity growth, strong foreign demand and increasing domestic demand, fuelled by a prolonged period of expansionary monetary policy and significant wealth effects. The key risk factors going into 2007 are increasingly stretched housing markets in Denmark, Norway and Sweden, as well as very tight labour markets in Denmark and Norway and a still loose but tightening labour market in Sweden.

Three factors suggests slower growth

With the exception of Norway, we expect the Nordic economies to slow during over the forecast horizon. The three main factors driving the slowdown will be a continued withdrawal of monetary stimulus, a gradual currency strengthening and — more fundamentally — the increasingly scarce labour resources. As small open economies, the Nordic economies are sensitive to developments in the global economy, in particular to developments in the euro area. On the upside — although it is not our baseline case — sustained structural productivity growth and increased immigration could subdue some of the expected growth slowdown and abate otherwise increasing wage pressures. On the downside, a more abrupt slowdown in house price growth — not to mention a drop in house prices — could significantly hamper household consumption going forward.

Loose monetary policy still fuels demand
Although monetary policy is still expansionary and spare production capacity increasingly scarce in the Nordic region, the continued withdrawal of monetary policy by Riksbanken, Norges Bank and the ECB is likely to gradually slow investment spending growth throughout the region. Despite ongoing monetary policy during 2006, monetary policy remains accommodative in all the Nordic countries. As Finland is a member of the euro area and Denmark has a fixed exchange rate towards the euro, the monetary tightening will be determined by the ECB (see Elga Bartsch’s note in this publication). In Norway and Sweden, we expect Norges Bank and Riksbanken to outpace the ECB through 2007 and to continue to withdraw monetary stimulus possibly through 2008 also. Financial conditions are likely to tighten further by a gradual currency strengthening. This will particularly be evident in Norway and Sweden, we think.

Tight labour markets and little immigration
Labour markets are tightening across the Nordic region. Labour markets in Denmark and Norway look particularly tight, while some slack remains in the labour markets in Sweden and Finland, we estimate. In Denmark and Norway, a rising proportion of companies are reporting labour shortage in several sectors ranked from construction and financial services through manufacturing. It is striking that the tight labour markets in Denmark and Norway has not led to a higher degree of wage inflation yet. Part of the explanation can be found in an increasing degree of flexibility in the labour markets, which has also resulted in a low rate of structural unemployment. Second, parts may be assigned to a higher degree of off-shoring. On our measure of structural unemployment (NAIRU), only the unemployment rates in Sweden and Finland are above the structural unemployment rate at present. Unemployment below the NAIRU in Denmark and Norway will likely cause upward pressure on wage growth over the forecast horizon.

Whether labour markets remain tight and result in increasing wage pressure will also depend on the labour supply from the new EU member states in particular. In recent years, a rise in the inflow of labour supply has been significant in Sweden only. Obtaining larger inflows of labour supply from the Central and Eastern European economies will become increasingly important to abate some of the labour market pressure in Norway and Denmark. On our baseline scenario, we would however still expect wage compensation and unit labour costs growth in Denmark and Norway to outpace wage growth in Sweden and Finland. Increasing the labour supply is especially important today. Facing an aging society across the Nordics, it is not a short-term issue. Depending on the developments in labour supply, we see significant downside risks to growth in the years ahead — particularly in Denmark and Norway.

Stretched housing markets a major risk factor
Housing markets in the Nordics look increasingly stretched, with the exception of Finland. In a recent OECD study, three of the Nordic countries are unfavourably ranked in the top-seven with respect to the probability of house prices ‘nearing a peak.’ In particular, the Danish housing market — ranked first among the OECD countries — looks prone for a potentially sharp adjustment. Across the Nordics, the rise in house prices over the last 10 years has been accompanied by a similar build up in household debt. Meanwhile, interest payments as a percent of disposable income have declined over the same period of time.

The drop in the ratio of interest payments to disposable income may not only be explained by decreasing interest rates over this period of time. Particularly in Denmark, the drop may have been exacerbated by an increasing share of short-term maturity and flexible rate borrowing. As such, Danish households, with the highest debt to income ratio in the Nordics, have become increasingly sensitive to developments in short-term interest rates. In Denmark, the unwinding of the house price bubble could be severe. As our colleagues David Miles and Melanie Baker recently pointed out in a study on the UK housing market, a large part of current UK valuations can be explained by expectations of further price rises only. Valuations are therefore very much dependant on expectations and could potentially be volatile (See UK Economics: How Did We Get Here? Nov. 22, 2006). Although this may also be the case in Denmark, a revaluation would still need a trigger. The massive rise in the number of houses for sale during recent months and stagnating sales prices may be exactly such a trigger. On balance, the potential abrupt slowdown in house prices constitutes a significant downside risk to consumption demand for Sweden and Denmark in particular. Meanwhile, our baseline case for Sweden and Norway remains for a gradual slowdown in house price appreciation. This may hamper consumption growth, but in Sweden this will likely be offset by the expected rise in household disposable income growth, induced by lower income taxes and employment growth.

Bottom line — Sweet Dreams or Nightmare?
The Nordic economies have shown impressive growth rates during recent years. In particular, demand has been fuelled by a very expansionary stance of monetary policy, but also productivity growth has been impressive on the supply side. Monetary policy is being gradually tightened, and the currencies are gradually strengthening. We therefore expect the economies to gradually slow, but for aggregate growth to remain above that of the euro area. Two risk factors in particular need to be addressed: labour markets and housing markets. Labour supply will need to be increased. In Sweden, this is already happening through increased immigration flows and changes in the tax base. The remaining Nordic economies are lagging behind in this respect. Housing markets look increasingly stretched; in particular, for Denmark, the unwinding of the housing bubble could be severe. There is still scope for sweet dreams in Sweden, but be prepared for potential nightmares in Denmark.

UK: Benign Central Case Belies the Risks

David Miles and Melanie Baker | London

We end 2006 with the economy and financial markets having had another decent year. GDP has risen consistently and, for the year as a whole, at marginally above what we estimate is the trend rate. Interest rates — in nominal and especially in real terms — remain low, and the exchange rate has been relatively stable on a trade-weighted basis, though on a more volatile upward path against the dollar. Unemployment has edged up but so has employment, while stock prices and house prices have moved higher over the year. But inflation ends the year substantially higher than at the start of the year, and we expect it to rise a little further early in 2007. There is a real risk that this triggers an acceleration in wage settlements; if RPI inflation is close to 4% in the spring, then no change in the pace of earnings growth would mean stagnant real incomes. Zero real wage growth is not implausible — in fact it is quite likely. But there are obvious risks that wage rises move up and interest rates are increased to reduce the chances of above target inflation becoming persistent. Even without interest rate rises, house prices look vulnerable in the UK. However, we are not convinced that falling house prices — themselves likely at some point — need trigger a sharp slowdown in consumer spending.

Central GDP projection: solid but lacklustre

Our central projection for the UK economy is for solid, but slightly sub-trend, growth in 2007. After 2.6% real GDP growth in 2006, we project 2.3% in 2007 and 2.5% in 2008. This forecast, however, embodies two key assumptions. First, potential growth has not risen and does not rise significantly; second, export-weighted global growth slows (very moderately). On the first, we assume that the pace of immigration seen in the UK since 2004 does not continue at quite such a high rate and that productivity growth remains rather disappointing. There has been no sign of any increase in the rate of productivity growth in the UK in recent years — indeed, the evidence, if anything, is to the contrary. On the second, our global economics team regards risks to the global outlook as skewed to the downside.

Components of GDP growth: a sluggish consumer

We continue to think that consumer spending will not pick up significantly in 2007, keeping overall growth subdued. Household savings still look on the low side, debt levels and debt service levels remain high, and risks are skewed to the downside in the housing market. Arguably, the low volatility environment we’ve seen in the UK over the past decade may have helped sow the seeds for a more volatile period ahead. Less fear of sharp gyrations in the economy has likely been a factor behind households building up very high levels of debt (which may leave the economy less able to weather shocks, such as a sharp move in interest rates or deterioration in the labour market, in 2007). With slower global growth, investment spending growth may decline a touch and the contribution from net exports may be marginally negative. Against that backdrop, growth slightly below the pace of 2006 seems likely to us in 2007.

Inflation: risks on the upside

In our central forecast, we see year-on-year inflation rising into the turn of 2006 before gradually declining towards 2.0% (the Bank of England’s target). We believe it is likely that GDP growth runs slightly below potential in 2007 and that current upward pressures on inflation, from factors including electricity and gas bills, diminish and then fall out of the year-on-year comparison. However, two main factors suggest that inflation risks lie more on the upside than the downside of that profile: 1) we think there is little spare capacity in the UK economy; and 2) wage increases may become more inflationary. So far, wage growth has been very benign, but a number of factors are coinciding at an important time for wage negotiations (the turn of the year). These give us some cause for believing that wage growth risks are on the upside across a range of sectors and job types. First, RPI inflation (more important in wage negotiations than CPI) is likely to rise towards 4.0% year on year by the beginning of 2007; second, the minimum wage rose 5.9% in October 2006; third, discretionary income (the amount of money households have left after paying taxes and energy bills and after debt repayments) has been squeezed, which may persuade some to push hard for higher wages; and fourth, profit growth has been relatively strong in the UK in 2006.

Interest rates: on hold with upside risks

With a central profile of around trend GDP growth and inflation remaining above target, but gradually declining over 2007, our central (single most likely) scenario is that interest rates remain on hold throughout 2007. However, with inflation risks still on the upside, we think that the risks to this profile for rates are skewed more in the direction of further rate rises rather than further cuts. Bond yields, however, end the year at levels that seem to imply little chance of interest rate increases of all but the most minor and temporary sort. Given that situation, we believe that gilts will move lower (yields move higher) in 2007. Equity prices seem more fairly to reflect risks and stock market valuations are more robust to the impact of a possible pick up in inflation and interest rates.

Politics: Continuity, despite changes

Tony Blair looks set to step down as Prime Minister some time in the first half of the year — probably close to the 10-year anniversary of his leadership in May. It is overwhelmingly likely that his successor will be Gordon Brown, who will inherit a substantial parliamentary majority and who will, as a result, be under no pressure to call an election. (There need be no election until 2010 so, in principle, the new Prime Minister will have almost three years before needing to face opposition parties at the polls; in practice, it is likely that an election is called before 2010). Since Brown has been in charge of the overall direction of economic policy for several years, the thrust of fiscal and monetary policy — including the policy of simply ignoring the option of adopting the Euro — looks set to continue. The strategy on spending and taxing will continue to be one where expenditure rises only marginally above 40% of GDP. But that will be a very tough strategy to implement — particularly with the 2012 Olympics approaching and significant infrastructure spending still required. Keeping overall government spending contained may prove very tough.

The Netherlands: Roundtrip

Elga Bartsch | London

The Dutch economy is the first country in the euro area that has successfully completed a full roundtrip in terms of relative growth performance. This is not only very good news for the Netherlands, which at 2.4% on our forecasts is set to grow above its own trend rate and above the European average next year. Thus, after several years of relatively meagre growth performance, the Netherlands is now firmly back in the European growth league. But the comeback of the Dutch economy is also very good news for the euro area, where the continued growth discrepancies have prompted discussion on whether there is a properly functioning adjustment mechanism that can correct these intra-EMU growth and inflation differentials (see EU Commission: Adjustment Dynamics in the Euro Area – Experiences and Challenges, November 22, 2006). Some observers have voiced worries that the adjustment process that would cause overheating countries to cool and underperforming ones to recover might not be powerful enough to correct these growth divergences. As the ECB’s monetary policy by definition has to be “one-size fits-all,” such deepening divides in terms of growth and inflation could potentially undermine the proper functioning of the currency union.

But the relative performance of the Dutch economy over the past ten years shows how such an adjustment mechanism can work successfully. However, to date the Netherlands is the only country that completed the full cycle. Germany could potentially be another such case, but we first have to see whether the current recovery proves to be a lasting one and whether it manages to withstand the cyclical headwinds it will face in 2007 (see German Economics: Putting the Recovery to the Test, December 15, 2006). Being small and very open, the Dutch economy very much feels the heartbeat of global trade cycle due to its role as a logistics hub. But it also feels the heartbeat of the intra-EMU tensions and the adjustment processes these can trigger. This is the reason why in my view the Dutch government was so quick to react to a marked decline in the deterioration of cost competitiveness vis-à-vis the rest of the euro area, and after consulting with trade unions and employers, the government essentially imposed a two-year wage freeze in 2003. The turnaround in the cost-competitiveness is one of the reasons for the smart rebound in Dutch growth, in my mind.

In the late 1990s, the Dutch economy was one of the star performers in Europe, and investors were referring to its stellar growth performance as the “Dutch miracle”. Policymakers from other parts of Europe considered copying the Polder model to revive growth dynamics while maintaining social cohesion. In 2001, however, the Dutch economy hit rock-bottom due to a combination of shocks; including the global equity market crash, a subsequent cooling of the Dutch housing market and a sharp rise in labour costs. During this period Dutch GDP growth fell short of the euro area average by a considerable margin, and sentiment indicators registered record lows that were even more depressed than the levels observed in neighbouring Germany.

Today, Dutch GDP growth is broad-based: consumption is picking up as a result of an increase in purchasing power and employment growth; export demand and investment spending are rising considerably. As a result, unemployment which at 3.9% of the labour force is already way below the Euroland average of 7.7% is decreasing rather rapidly. Increasing labour supply is a key issue for the long-term growth prospects of the Dutch economy. But as in the UK, there is substantial hidden unemployment amongst people on disability and early retirement schemes. A key aspect in boosting labour supply in the Netherlands will be to encourage people to work longer hours, thereby reversing a trend towards part-time work, which has reduced the average work-week in the Netherlands to around 30 hours. Nevertheless, inflation and wage developments are expected to remain moderate in 2007 and stay well below the euro-area average; thus further improving the competitive position of the Netherlands. For the first time since the boom year 2000, the general government budget will be in the black again. In addition to a reduction in corporate tax from 29.1% to 25.5%, various relief measures (including an income tax cut for low income earners) will provide overall tax relief of EUR 1 billion (equivalent 0.25 % of GDP).

Looking at the election results. Notwithstanding the turnaround in the economy and an impressive track record on reforms, the centre-right government led by Jan-Peter Balkenende suffered a major defeat at the general election held on November 22. The surprising winners of the general elections were the populist left-wing Socialist Party as well as a number of smaller parties at the fringes of the political spectrum. Contrary to Germany, the two main parties in the Netherlands don’t even have enough seats to form a “purple” coalition, the Dutch equivalent of Chanceller Merkel’s “grand” coalition bringing together the country’s two largest political parties. This increasing fragmentation of the political spectrum, where extremist parties both on the left and on right gain at the expense of the political centre, likely reflects the bifurcating forces of globalisation. In the Netherlands, alas, it might take several months before a new government is being formed.

Italy: Flickers of Light

Vladimir Pillonca | London

For the first time in a decade, there are positive signs of change, and a medium-term improvement of Italy’s macro performance is becoming a more concrete possibility. We are finally witnessing two crucial changes from Italy’s policymakers: 1) acknowledgement that Italy has serious long-term economic problems; and 2) willingness to tackle these problems. For example, the government has reduced the huge debt burden and liberalized key sectors of the economy, ranging from banking to the retail sector, as outlined in the recently made effective Bersani Decree.

Provided the current government coalition holds, the next few years could provide the foundation for higher future economic growth. The beginning of the legislature is the ideal time to push on with reforms, some of which will be painful in the near term. This will likely diminish popular support for the government in the short term, raising political uncertainty. But not only will supply-side reforms be instrumental in raising Italy’s sustainable longer-term growth, they will also make the reduction of Italy’s enormous debt burden a more manageable task, increasing the longer-term attractiveness of investing in Italy.

Flickers — not sparks

Italy’s economic growth has been strong this year, following a decade of chronic macro underperformance: GDP growth averaged just 1.4%Y in 1995-2005, compared with 2.1% in the euro area and 2.8% in the UK. Reversing Italy’s persistently negative growth differential will take time — but an improvement relative to its own recent history is becoming a more concrete possibility. The government’s initiative to liberalize services is an essential step toward strengthening the services sector, while encouraging competition. Encouraging competition in the services sector should help to reduce Italy’s exposure to the internationally competitive and volatile manufacturing sector. This is also an important step toward boosting potential growth, and one of the reasons why we are positive on Italy — provided the reform effort intensifies.

Clever consumers avert recessions

Next year marks an important test for the Italian economy: a significant degree of fiscal tightening takes place domestically, while a VAT hike becomes effective in Germany, a key export market for Italian firms. In principle, next year’s fiscal tightening could trigger a recession and could have a particularly adverse effect on consumption. However, we expect consumers to behave in a forward-looking rational way, and to look through the temporary phase of higher fiscal pressure, and lower economic growth in 2007, in anticipation of higher economic growth in 2008 and beyond. The expectation of higher growth in the future could strengthen if the reform effort gathers pace, underpinning confidence. Consumers don’t typically allow their consumption to fluctuate as much as their income; instead, they smooth their consumption expenditure over their life cycle, even when their income falls temporarily. It is the longer-term expectation of the future stream of income that tends to dictate consumption patterns. This explains why the volatility of consumption is normally much lower than that of consumers’ disposable income. Hence consumer spending could hold up relatively well next year, while the savings ratio falls slightly, though admittedly there are downside risks to our central consumption forecasts. Besides, the payroll tax wedge will be cut by five percentage points next year, which should help to insulate consumers’ take-home pay from income tax increases, which will mostly affect higher-earning individuals and holders of financial assets. Finally, we expect annual CPI inflation to decline to 1.7% in 2007, while nominal wage growth is unlikely to edge much lower than 3.0%Y, implying approximately a 1% gain in real wages.

Credit deepening and corporate awakening

Households’ access to credit has improved in recent years, and loan-to-value (LTV) ratios have risen. Italy’s mortgage debt/GDP ratio has increased from 10% in 2000 to 17.2% by the end of 2005. But even so, consumers’ mortgage debt/GDP ratio remains relatively low at 17% in Italy, compared with 52% in Germany and 80% in the UK. Rising interest rates might slow credit deepening in the near term, but we think this process has further to go in Italy over the medium term. On the corporate side, our tentative impression is that the restructuring process is at a barely nascent stage, and is more likely to start with the larger corporates. We expect fixed investments to rise in line with GDP growth in 2007, and to pick up appreciably in 2008. M&A activity has the potential to extend beyond the banking sector, but stringent labour protection laws suggest that the restructuring process is likely to be a slow-moving phenomenon. If reforms do progress, the corporate environment should improve, and the room for improvement is large.

Bumpy outlook ahead — but no crashes in sight

A sharper US or global slowdown than we expect would imply downside risks to our central euro area forecasts. In our central case, GDP growth in the euro area slows from 2.6%Y this year to 1.9%Y in 2007, before picking up again in 2008. Next year’s slowdown also reflects fiscal tightening in Germany and Italy, the lagged effects of higher interest rates and a strong euro. In Italy, we forecast GDP growth to slow to 1.1%Y in 2007 from 1.8%Y this year. This projected slowdown would amount to a robust performance by Italian standards, especially given the significant degree of domestic fiscal tightening, while Germany’s VAT hike will likely curb demand for Italian exports. So, we expect net exports to be neutral on growth next year, after adding to GDP growth in 2006. While fiscal tightening should be enough to push the budget deficit down to 3.0% of GDP next year, it won’t be enough to position Italy’s massive stock of debt on a lasting downward path. For this reason, fiscal policy is likely to remain tight beyond 2007.

Risks and alternative scenarios

While the above discussion focused on a central scenario, there are two representative alternative scenarios worth highlighting:

i) Negative scenario: Fiscal hangover cracks fragile recovery

Under this scenario, consumption growth slows in 2007, reflecting the impact of an effective increase in tax pressure. The VAT hike in Germany in 2007 reduces demand for Italian exports in 2007, while a strong euro has an adverse effect on many Italian firms’ fragile competitive position. Any combination of these factors could advance Italy into yet another phase of low growth or even an outright recession.

ii) Optimistic scenario — a low probability event

Under this scenario, a series of coincidences would have to materialize simultaneously: i) GDP growth remains significantly above trend across the euro area, particularly in Germany, despite the VAT hike, while global and US growth defy expectations of a slowdown; ii) much lower energy prices result in significantly lower inflation, underpinning households’ purchasing power much more markedly than in our central case; and iii) a sharp drop in consumers’ savings ratio, as consumers significantly increase their debt levels. The probability of these events occurring concurrently is very low, in our view.

Distribution and assessment of risks: Our central GDP growth forecast is closer to the positive case than the negative scenario, but there are many risks on the horizon, coming from multiple directions. Political instability could thwart the reform effort, fiscal policy could have more of a restrictive impact than we anticipate, and a persistently strong euro could undermine the fragile competitive position of many Italian firms, especially in the manufacturing sector. Overall, we feel risks are skewed to the downside of our central forecast for economic growth.

A more in-depth report on Italy’s outlook is available: See “Flickers of Light at the End of the Tunnel,” December 2006.

France: We Have a Problem, Mr(s) President

Eric Chaney | Paris

2007 is an important year for France. First, the macro environment will be less friendly for growth and profits than it was in 2006, since France’s two main trading partners, Germany and Italy, are undertaking major fiscal consolidations that should slow their imports. Second, the presidential election, immediately followed by parliamentary elections, will give the country a new leadership for the next five years. In a context of still low interest rates, domestic demand should be robust enough to allow the economy to grow by around 1.9%, i.e., only a couple of tenths below potential. However, tougher competition from German producers – the VAT rate hike is partially financed by exporters to Germany but not by German exporters — combined with a stronger euro and slower global demand will squeeze profit margins and make companies more reluctant to hire.

The risk of populism in the electoral debate

Against this tepid macro backdrop, I see a significant risk that the political debate might drift toward populism, as it has already started to do. Candidates from either side of the political spectrum may find it rewarding to overbid on themes such as the mandate of the European Central Bank, household purchasing power, or globalisation. Changing the ECB’s mandate in order to include growth and employment in the bank’s targets is totally unrealistic: It would require a unanimous view from all EMU countries, which has a zero probability. All candidates know that fact; they are also aware that the financial markets do not really care about these statements, because traders cannot short the French franc as they would certainly have done eight years ago.

However, this behaviour may weaken the credibility of the next government regarding EMU governance issues and, in any case, reinforces the impression that French politicians are more interventionist than ever, which cannot be good for investment. Increasing purchasing power by either raising the minimum wage or distributing more taxpayers’ money to low income families is a more serious threat in my view, against a backdrop of eroded competitiveness and record high government spending (53.8% of GDP in 2005). Also, letting French voters think that policy makers have the power to insulate the economy from globalisation is a dangerous illusion: Even though promises on that front are cheap, they have dangerous side effects such as increasing capital outflows and reinforcing domestic rigidities. This brings me to the broader picture and to the challenges the French economy is facing.

We have a problem, Mr(s) President

Three indicators show how serious are these challenges. First, French exports outside of the euro area are 16% lower than at the outset of the monetary union, relative to EMU exports. Comparable numbers for Germany, Italy and Spain are respectively +11%, -1% and +2%. In this zero sum game, France is the loser, Germany is the winner, while Italy and Spain have broadly maintained their relative positions. Although the time frame is somewhat arbitrary – at the outset of EMU, Germany’s competitive position was still deeply damaged by the consequences of the unification — this rough competitiveness indicator is consistent with more elaborate studies (see for instance Pr. Lionel Fontagné and Patrick Artus’ report to the Council of Economic Analysis, ‘Recent trends in French foreign trade’, 2006). Second, French unemployment, at 8.8% (October 2006, Eurostat definition) is now the second highest in the euro area, just behind Greece, and more than a full point above the euro area average (7.7%). Third, the share of wage earners at the minimum wage level has risen to 16.5%, while it was less than 10% in 1996. Not only does this imply that rigidities have increased since 1997, but also that unemployment could rise disproportionately during the next downturn. If his or her economic advisor dares tell the truth, the first words the next President of the French Republic hears from him should be: “We have a problem, Mr(s ) President”.

Three priorities for the next President

I believe that three reforms should be undertaken in the very first period of the President’s mandate: 1/ labour markets, 2/ public finances and 3/ deregulation of services. Without entering into the details, the labour market reform should tackle the minimum wage abscess, by freezing its real value until the share of minimum wage earners is back below 10%. Also, the government should introduce a new generic labour contract which would allow employers to fire employees without obstacles, in exchange for a progressive severance compensation (an idea promoted by Pr. Olivier Blanchard of the MIT, among others). Progressively, this would cure what I have called the ‘insider disease’ that characterizes the labour market rigidities and generates dangerous frustrations in French society.

As for public finances, the main target of the reform in a first stage should be to reduce welfare spending (social transfers), in particular medical spending. The spirit of the healthcare system, i.e., guaranteeing free access to medicine with very few restrictions, is naturally generating inefficiencies and waste. At stake is nothing less than unemployment: since the healthcare system is mostly financed by payroll taxes, every euro saved would reduce the cost of labour and thus help create jobs. Last, deregulating services, from the retail sector to hotels, cafes and restaurants, is the surest way to create jobs in France, given that, in manufacturing, globalisation will continue to reduce headcounts, especially at the low end of the qualification ladder. In this regard, freezing the minimum wage would help considerably in low-skilled labour-intensive services, as well as cutting payroll taxes. This last remark shows how entangled are the three fields I have selected and answers the priority question. All three reforms should be undertaken simultaneously in order to create a virtuous circle of job creation and support from the population.

There is nevertheless a priority: Tell the truth to the French. If, as in 1981, 1988, 1995, and 2002, candidates tell fairy tales to voters, history might repeat itself: Reforms would progress at a snail’s pace while the world accelerates, a trap I once called the “White Queen Syndrome”.

Germany: Putting the Recovery to the Test

Elga Bartsch | London

In 2007, the much-applauded economic recovery in Germany and, more importantly, financial markets’ conviction in the revival story, will be put to the test, I think. This is because a number of negative factors will likely weigh on GDP growth in the coming months. The key question is by how much. My main-case scenario is that after several years of heavy restructuring, the economy should now be in better position to withstand negative headwinds without falling back into its old ways of dipping in and out of stagnation. On our forecast, real GDP growth will nonetheless slow from an estimated 2.5% in 2006 to its trend rate of 1.5% in 2007. This is two-tenths above consensus estimates in each of the years.

Don’t be fooled by the decline of the annual average growth rate though. The decline is almost entirely due to a negative real GDP growth rate in the first quarter of 2007. This forecast of an outright contraction in economic activity in early 2007 reflects a three-point VAT hike becoming effective on January 1st and a considerable fiscal consolidation package of around 0.75% of GDP of which it is a key part. But the German economy should be recovering from this shock as early as the second quarter. Due to the substantial hike in the VAT, consumer spending will feel the brunt of the fiscal tightening in 2007. As a result, consumer spending growth will likely halve from the 1.1%, it is likely to register in 2006. A considerable part of that weakness in consumer spending will simply be a payback after purchases of big ticket items that have been brought forward to late 2006 to avoid the higher VAT. A similar but less pronounced pattern is likely to be observed in residential construction investment. Notwithstanding such a temporary setback, the German construction industry is emerging from a multiyear recession, in my view.

Slowdown likely in machinery/equipment spending growth. Meanwhile, corporate spending on machinery and equipment, which has been a major driver of the recovery in the past few quarters, will likely to show moderation in growth rates in 2007 as profit growth slows, interest rates rise and wage bills increase. In late 2007, the prospects of tightening the depreciation rules under the planned corporate reform could provide a temporary boost to corporate investment spending. Given that pricing power is still limited in many sectors it is also likely that companies will have to absorb a part of the VAT increase in their profit margins. The downward pressure on profit margins will only be partially offset by a reduction in non-wage labour costs due to a cut in unemployment insurance contributions. A 2.3% reduction in the contribution rate to the statutory unemployment insurance will further boost cost-competitiveness of German companies, I believe. This along with the past wage moderation and still rapid labour productivity growth would act as boon against any further marked appreciation of the euro.

Internal tensions in the euro area could rise in 2007. The further improvement of the cost-competitiveness of German companies vis-à-vis their euro area peers will likely cause economic and political tensions within the euro area to rise next year. Germany’s unit labour cost dynamics have already been falling short of the euro area average by nearly 20 percentage points over the last 10 years, and the marked reduction in non-wage labour costs next year is likely to deepen the divide even further. As a result, export market shares should develop further in Germany’s favour. Some of the neighbouring countries, where domestic demand dynamics seem to have come off the boil as local house price momentum cools, might be looking at the combination of a cut in non-wage labour costs and a rise in the VAT as a new version of beggar-my-neighbour policies within a fixed exchange rate system. While such concerns are understandable, in my view, they miss the key point: the gales of globalisation.

German companies are not restructuring to take away market share from their French, Italian or Spanish competitors. They are restructuring to survive in the face of low cost competition from Central and Eastern Europe and Southeast Asia. As a high-wage country with above-average exposure to export destinations outside the euro area and a traditional capital exporter, Germany was the first to feel — and to react to — the gales of globalisation and their impact on the relationship between capital and labour seen in many industrialised countries. Other euro area countries will need to follow sooner or later in the recalibration of the share of wages and profits in national income seen in Germany in the last few years. But a potential rise in intra-euro area imbalances may also fuel political tensions within the European Union as long as governments remain in denial on how rapidly the global economy has changed already.

There can be no mistaking the risk of several negative factors causing a bigger than expected dent in German GDP growth over next 6–12 months. These negative factors, potentially hurting the cyclical growth momentum by more than expected include a three-point VAT hike implemented in January as part of a considerable fiscal consolidation package, a more pronounced slowdown in export demand due to cooling trade growth and a stronger euro, the lagged impact of past increases in interest rates and bond yields, the proclaimed end of wage moderation propagated by trade unions, and the introduction of minimum wages muted by the government reducing incentives for companies to hire and invest in Germany. On the positive side, the recent rebound in a number of sentiment indicators — such as hiring intentions for instance — suggest that the underlying momentum of the economy might be stronger than most forecasters (ourselves included) currently acknowledge.

In my view, the likely pullback in German GDP growth in early 2007 provides an opportunity to value-oriented investors to revisit the great restructuring stories in corporate Germany. A combination of slower top-line growth, rising margin pressure and a stronger currency will reinforce the need for strict cost-control and capital discipline. So make sure you have a list of best stock ideas handy when business sentiment starts to rebound. Historically, it was when the Ifo business climate started to rebound that the more cyclical German stock market outperformed its European peers.

Europe: The ECB's Balancing Act

Elga Bartsch | London

So far, tightening monetary policy in the euro area was easy. Coming from a record low of 2% for its main refinancing rate, the ECB Council was unanimously in favour of a gradual withdrawal of monetary stimulus over the last 12 months. Throughout the first year of the new ECB interest rate cycle, inflation and GDP growth forecasts were steadily upgraded providing arguments for nudging interest rates higher. Money markets and ECB watchers, by and large, anticipated the future course of ECB action correctly thanks to a set of code words signaling the timing of the next move. Financial markets took the ECB’s tightening campaign in stride. The common currency grinded higher only gradually, with the brief exception of a more rapid rise in late November. Yields of longer-dated government bonds hovered in a trading range between 3.5 and 4.0% for most of the year. The next 12 months are likely to demand a much more delicate balancing act from the ECB, in our view.

We expect the ECB to hike interest rates further in 2007 — in the light of GDP growth at or above trend, ongoing robust job creation, and rapid money and credit growth. We forecast a total of 50 bps of ECB interest rate hikes by December 2007. This compares with market expectations of slightly more than 25 bps. A total tightening of 50 bps would constitute a noticeable slowdown in the pace of tightening compared with the ‘every-other-meeting’ pace pursued in the second half of 2006. The much more gradual tempo of tightening reflects the fact that the ECB would be pushing the refi rate towards the upper end of the neutral range, which we estimated to be between 3.5% and 4.0%. Even though the inflation outlook isn’t showing significant pressures at present, the risks remain tilted to upside, in the view of the ECB. This perception was emphasised again in the December press conference. Even though that press briefing gave conflicting signals with regard to the timing of the next move, we still believe that the most likely timeframe is March. But by stating that it “monitors risks to price stability very closely” — a phrase that in the past indicated that the next rate hike was only two meetings away — February is a possibility too.

Against this backdrop of further ECB tightening, we expect ten-year Bund yields to rise from the current 3.76% level and eventually break markedly above 4% in 2007. Demand for long-dated bonds, a moderation in nominal GDP growth and pre-emptive monetary policy action will likely limit the rise in bond yields at the far end of the yield curve though. As a result, would not even rule out a renewed inversion of the yield curve in the next 6–9 months. When the spread between the ten-year Bund and two-year Schatz briefly dipped into the red in November, investors debated whether this would signal a recession. This debate could resurface if the spread would move into negative territory again. Historically, the yield curve has been the most reliable leading indicator for recessions. But a number of factors distorting the long-end of the bond market suggest that the message is less clear today (see Debating the Yield Curve, November 25, 2005 by our Global Economics and Strategy Team). These factors range from pension fund demand, central bank buying, compressed term-premia to excess liquidity and/or a savings glut.

The discussion about the ECB’s appropriate policy stance — both within the Governing Council and outside — is expected to become much more controversial in the coming year than it was in the year just ending; for the following reasons: First, at a refi rate of 3.5% euro area short rates are getting closer to the neutral level, which we would deem to be between 3.5% and 4.0%. While there was broad agreement that the bank should gradually take its foot off the monetary accelerator, whether it might need to push interest rates towards the restrictive end of the neutral range (or even higher) will likely be debated much more heatedly. The ECB itself uses a broader concept than just the short rate to assess the stance of its monetary policy. The rapid rate of expansion in monetary aggregates is one of the reasons why it is still regarding its monetary policy as accommodative. Second, the euro economy is likely to enter into a phase where risks to growth are tilted to downside and risks to inflation to the upside. The combination of moderating real GDP growth and intensifying inflation pressures always makes an awkward mix for a central bank. This also holds for a central bank that — like the ECB — gives precedence to inflation concerns.

Third, the ECB might find its policy decisions getting more than the usual amount of unsolicited advice from politicians as France heads for a presidential election, as domestic demand growth cools, and as the currency strengthens. While an independent central bank is unlikely to pay much attention to such broadcasts, this does not make its task any easier, especially in communication with the public at large. Fourth, the two pillars of the ECB monetary policy strategy — the broad-based inflation outlook and the monetary analysis — might soon send diverging signals. The persistent, strong expansion of monetary aggregates will likely continue to signal upside risks to price stability even after the broad-based inflation outlook stopped signaling such risks. Strong money supply growth caused the present tightening campaign to start earlier. It could also cause it to last longer (see EuroTower Insights: The Meaning of Money, November, 13, 2006). Finally, the uncertainty about the near-term economic outlook seems to be on rise at present. The unknowns include whether the US economy will be able to avoid a hard landing this winter, whether the German economy will be able withstand a three-point VAT hike, and whether financial market volatility could show a renewed rise.

A year of challenges. To sum up, the year in which the euro area will welcome its thirteenth member — Slovenia — is likely to hold several challenges for ECB policymakers as the bank’s refi rate approaches the neutral level. Hence, discussions about the appropriate policy stance both within the Council and outside will likely liven up. After a year of successfully micro-managing money market expectations by using a standard set of code words (see EuroTower Insights: Too Much Communication?, May 19, 2006), ECB Council members might start to send much more mixed messages in 2007 as the bank attempts to delicately balance a number of different factors.

Europe: About Decoupling, Reforms and Tensions

Eric Chaney | London

The short-term outlook for the euro area is clouded by major macro uncertainties, from the nature of the slowdown in the US to the consequences of a three-point VAT rate hike in Germany, effective on January 1. Yet we believe that the domestic recovery, fuelled by a powerful monetary stimulus and structural improvements such as faster productivity and more flexible labor markets, should provide a robust base for growth next year. While GDP growth should decelerate significantly, from 2.7% in 2006 to 1.9% in 2007, on our forecasts, the consequences of the VAT hike in Germany should be limited, being fully anticipated by German consumers and companies operating on the German market. Nevertheless, uncertainties are so high that financial markets may turn much more volatile than they were in 2006. These uncertainties will likely also cause the ECB to approach further tightening more cautiously (see Elga Bartsch’s “The ECB’s Balancing Act” in this issue).

While increasing risks for investors, volatility also generates investment opportunities. Here are three macro themes that could provide investors with such opportunities: US-Europe decoupling; labor market reforms and tensions between capital and politics.

1. A ‘soft decoupling’ between the US and Europe. A widespread view in the markets is that Europe follows the US cycle with a six-month lag. This theory may regain popularity, but for the wrong reasons, we believe: growth is likely to slow in Europe in the first months of 2007, for domestic reasons — a 150 basis point monetary tightening by the ECB and a 0.6% of EMU GDP fiscal tightening in the German and Italian budgets. Rather, we anticipate a ‘soft decoupling’ between the US and Europe: GDP growth falling significantly below trend in the US while decelerating towards trend in Europe. Because domestic demand is the main driver of growth in both regions, business cycles are not necessarily synchronized. For sure, financial linkages matter, as we learned during the previous downturn, when European companies slashed investment projects from 2001 to 2003. Massive capital outflows to the US — mostly driven by acquisitions — at the outset of EMU had made investment projects by European companies highly sensitive to the US capex cycle. However, this time, the US slowdown is coming from housing investment, to which neither companies nor investors in Europe seem to be exposed. As we see it, once fiscal policies relax their grip, growth should re-accelerate in Europe, where the personal savings rate should decline further, while the US economy is likely to continue to grow below trend speed, as the personal savings rate rises. Thus, ‘hard’ decoupling could become a popular theme in the course of the year.

2. Labor markets: end of ‘easy reforms’? So far the rapid decline in euro area unemployment hasn't fuelled wage inflation, a sign that structural unemployment is steadily declining. Policies aimed at reducing the cost of low-skilled jobs (by cutting social contributions most of the time) have worked, but their unwelcome side effect was the creation of two-tier labor markets. Also, the secular upward trend in the female participation rate is increasing the share of flexi-jobs, on trend, which helps reduce structural unemployment. However, with euro area unemployment likely to ebb towards 7% in the next 12–18 months, tensions in labor markets may appear, leading to higher wage inflation. Since dual labor markets generate inefficiencies and social tensions, governments will have to consider more far-reaching reforms, such as relaxing wage-bargaining systems, removing obstacles to redundancies or simplifying labor contracts. Labor market policies are likely to be hotly debated ahead of the French presidential election but could also return to the forefront of political debate in Italy and Germany. More ambitious reforms would probably help the ECB keep rates lower, thus boosting growth and profits.

3. Watch tensions between capital and politicians. Together with ample liquidity, rising cross-border capital flows within the single currency area and divergent dynamics in domestic demand have fuelled rising current account imbalances. While Spain is heading towards a double-digit current account deficit to GDP ratio, Germany and the Netherlands are both running a current account surplus to GDP ratio of similar magnitude. A potential rise in intra-EMU imbalances may fuel political tensions, we think, against a general backdrop of anti-globalization sentiment. Interestingly, in the new EU member states, capital inflows also seem to fuel political tensions here and there. With slower growth ahead and large war chests accumulated in previous years making companies more aggressive, tensions may rise further next year. Taking a longer-term view, political leaders seem to have largely underestimated the practical implications of the European Monetary Union and of the EU enlargement: with capital easily crossing borders, restructuring has become a permanent and obsessive theme for European companies. The result is that companies operating on a pan-European basis and having global ambitions have a growing influence on economies, while governments have less. The tug-of-war between the power of capital moving freely across borders, while most workers won’t, and institutions changing slowly, creates investment opportunities. For that, investors need to pay attention to two elements: political resistance, which differs across countries and sectors, but also the long-term picture, which is in my view the emergence of large global companies operating from their historical European base.

Latin America: A Dose of Stability

Gray Newman, Luis Arcentales and Daniel Volberg | New York

As the risks surrounding a global slowdown increase, it might seem overly optimistic to be upbeat on the prospects for Latin America for 2007. After all, the region has benefited in recent years from a period of unprecedented Chinese demand that has boosted prices for commodities from the region and contributed to a prolonged bout of above-trend US growth and low interest rates. Interest rates have now been rising around the globe, the US economy has slumped in the post-housing-bubble shakeout, and there is increasing debate over whether China will engineer a successful moderation of growth. Meanwhile, the region continues to have its “problem countries.” In the past month, Hugo Chavez was re-elected as president in Venezuela, and Ecuador voted in a new president who campaigned on the moral need to repudiate the country’s debt. Still, we are optimistic about Latin America.

Latin America is benefiting from the arrival of macro stability and a dose, however partial, of certainty. In a region where growth has frequently been punctured by crises that have brought down currencies, economic models, and heads of state, the mere fact that 2007 should mark the fifth year of good growth and low inflation is an important accomplishment. Is it enough? Most certainly not. Most of the region’s inhabitants still suffer from glaring shortcomings — from inadequate healthcare and education to an irregular regulatory framework — all of which have limited stronger growth in productivity. But we would argue against underestimating the power of a dose of stability.

Perhaps nowhere is the change that the region is undergoing clearer than in Brazil. Just four years ago this month, Brazil watchers were engaged in a debate over whether the country was on a path leading to debt default and capital controls. Today, Brazil has zero net public external debt (net of international reserves), a declining debt path for its domestic debt, and inflation hovering around that of the US.

Benefits from Macro Stability Should Not Be Underestimated

Our optimism on Brazil might seem mistaken. Indeed, Brazil’s disappointing growth record has prompted calls from within the global economics team at Morgan Stanley to strip the country of its place within the BRICs (see “Hitting a BRIC Wall,” in This Week in Latin America, September 25, 2006). But we would argue that this is precisely the wrong moment to disqualify Brazil from its place within the BRICs. We suspect that Brazil is on the verge of much stronger growth in 2007 and in the coming years, as it delivers continuity on the macro front of the sort that we have seen in recent years.

Our upbeat assessment on Brazil’s growth path in 2007 is predicated on our view that there is a strong case for significant interest rate reduction. Indeed, perhaps nowhere in the emerging markets is the case for a reduction in rates stronger than in Brazil. Inflation has plummeted even as real rates have remained largely unchanged. And that, we believe, sets Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates.

We expect the targeted Selic interest rate to reach 11.25% by the end of 2007 and to fall further in 2008. With projected real rates at their lowest level in decades, we expect Brazil’s growth path to improve. Of course, the challenge is not simply a matter of monetary policy. The economy needs a stronger investment platform, and that means changes in the regulatory environment, improved infrastructure, and a healthier public sector. But the benefits from stability and hence lower interest rates are likely to prove powerful forces boosting the investment cycle in Brazil.

Looking elsewhere in the region, even in Mexico there is still room for progress. Although we are less optimistic about the new administration’s ability to build the much-needed consensus for reforms on the fiscal and energy fronts, there is still room for progress on the stealth reform agenda. Low inflation — core inflation has been running within Banco de Mexico’s target range for the past four years — has begat a dramatic extension of the yield curve and the birth of mortgages and credit to those who had long been beyond the reach of financial intermediaries. That trend is likely to continue uninterrupted in 2007 and provide a significant cushion to a slowing export-based manufacturing sector.

And we still expect Argentina to remain the fastest-growing economy in the region despite its distortionary policy mix. While price controls, negative real interest rates, a heavily managed exchange rate appreciation, and export regulations aimed at controlling inflationary pressures are not long-term sustainable policies, the long term is unlikely to arrive in 2007. Even in the most vulnerable sector, namely electricity generation, we see no major dislocations in 2007. In fact, we expect the economy to keep powering ahead, with domestic consumption doing most of the heavy lifting through expanding credit, a real estate market boom, and rising real incomes.

Bottom Line

We are fairly upbeat on the prospects for Latin America for 2007. If our global team is right and the world sees good, albeit slower growth, Latin America should post another above-trend result. Now five years into the current growth upturn, we have seen little of the excesses of past upturns in the region. The current cycle has not produced the ballooning trade and current-account deficits fueled by consumer spending seen in the past, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies. Thus, while the region is hardly immune to a potential global slowdown, we suspect the consequences would be much milder than in the past and would ultimately strengthen the region’s newfound stability.

United States: CPI - A Shocking Development

David Greenlaw | New York

There have certainly been bigger market movers in recent years, but Friday’s CPI report was one of the most shocking data releases in memory. The reason -- unlike employment numbers or retail sales data -- the CPI figures tend to exhibit very little month-to-month volatility. In fact, a forecast miss of 0.2 percentage points on the core CPI is about a two standard deviation event. To put it another way, over the past 10 years, the core CPI outcome has been 0.2 percentage points higher or lower than the consensus on only 8 occasions (or 6.7% of the time). Most importantly, when such a surprise does occur, it is almost always traceable to a big move in a single volatile component -- such as tobacco or hotel rates. In this case, there was no such sole special factor responsible. And, to top it all off, the big downside surprise in November followed on the heels of a notable -- although not quite as large -- downside surprise in October.

Friday’s report was particularly shocking from another standpoint. Mathematically, it is virtually impossible to get a 0.0% result for the core when the shelter category, which accounts for 41.7% of the core, is up 0.4%. Yet that is exactly what happened in November. As seen in the accompanying figure, the core CPI excluding shelter was -0.2% in November -- the lowest reading in the 40-year history of the data.

From our standpoint there are three possible explanations for the sharp deceleration seen in the core CPI over the past two months.

1) The data are correct and should be taken at face value. Core inflation experienced a significant run-up in the first nine months of the year (rising from around +2.0% to a +2.9% yr/yr rate in September) and we are now simply seeing a rapid unwind, reflecting the pullback in energy prices and a weaker economy. Of course, the problem with this story is that the transmission from energy prices to consumer prices is hardly instantaneous. It takes at least a few months -- if not a few quarters -- for this chain of events to play out. Moreover, while economic growth has slowed, labor markets remain very tight and cost pressures -- even after taking into account the latest revisions -- continue to edge gradually higher. We assign about a 20% probability to this scenario.

2) The October and November data reflect statistical quirks that will be unwound in relatively short order. While there was no single special factor responsible for the much lower than expected core CPI results over the past couple of months, some of the categories that played important roles simply do not seem to square with reality. Two obvious such items are motor vehicles and air fares. Automakers have pared production dramatically over the course of 2006 so that they could discount less -- not more. Indeed, vehicle inventories at the end of November were at their lowest level for that particular month in the past five years -- hardly a recipe for a stepped-up pace of price cuts. Meanwhile, airline industry load factors remain quite elevated and industry pricing data simply do not support the notion that there have been sizeable fare reductions of late. It’s certainly conceivable that we will see a sharp rebound in vehicle prices and air fares along with a flattening out of apparel prices and a continued escalation in OER over the course of coming months. This could put us right back at a +2.9% yr/yr rate by February. We assign about a 35% probability to this scenario.

3) Finally, it’s quite possible that the October and November data merely reflect an unwind of some quirks which had temporarily elevated the core CPI readings in the first three quarters of the year. In other words, both the prior up moves and the down moves of late have merely reflected statistical noise. Core inflation has actually been holding fairly steady all along. One possible culprit in this scenario is inadequate seasonal adjustment. Interestingly, in both 2004 and 2005, the core CPI experienced a run-up in the early part of the year followed by significant deceleration later on. While this seems to us to be the most likely scenario -- we assign it a 45% probability -- there are still plenty of unanswered question. Specifically, while a seasonal bias may be evident in the data over the past few years, the swings in both 2004 and 2005 are almost entirely attributable to big moves in a single volatile category -- hotel rates. And, there does not appear to be any sign of such a seasonal bias in the core CPI for the 10 years or so prior to 2004.

In the end, only time will help tell us which one of these scenarios best explains the swings in the core CPI over the course of 2006. In the meantime, it seems reasonable to assume that the inflation picture is not as scary as previously feared. However, with labor markets still tight, with productivity showing signs of some modest cyclical slowing, and with energy prices remaining quite elevated relative to a few years ago, it would be wrong to assume that inflation risk has disappeared entirely.

United States: Business Conditions - Bouncing Along the Bottom

Shital Patel and Richard Berner | New York

Business conditions continued to deteriorate, remaining below 50% for the seventh consecutive month, but the deterioration isn’t intensifying. The Morgan Stanley Business Conditions Index (MSBCI) increased by four points in early December to 44%, retracing some of November’s decline. The less-volatile three-month moving average edged up two points to 43%, the highest level since August. At 43%, the fourth quarter average only stands one point above the third quarter average, meaning analysts are essentially just as pessimistic in the current quarter as they were last quarter.

Last month we noted that our bullish forecasts were out of sync with gloomy analyst reports, although we admitted that analysts were more accurate on conditions in the 3rd quarter than we were. Earlier this week, given incoming data, we sharply lowered our near-term GDP forecast, with the three quarter growth rate ending in 1Q07 averaging only 2%. However, there are also glimmers of improvement: A positive employment report and a blow-out retail sales report have led us to revise our current quarter GDP tracking estimate up 0.9 pp to 2.5%. Furthermore, advance bookings were higher in the Empire State manufacturing survey. Score: Analysts 1: Economists 1? The jury is still out!

Results from this month’s survey suggest that analysts may be preoccupied with slower volume growth and fading pricing power, leading to lower top-line results in nominal terms. On the volume side, the advance bookings index declined three points to 40%, the lowest level of the index since April 2003. Also, our pricing conditions index plunged twelve points to 51%, the lowest level since January 2005. The breadth of responses was roughly equal between lower prices compared to a year ago, unchanged prices, and higher prices; only one-third of analysts said that companies have increased prices, down from the peak of 64% in February.

So what about the bottom line? Despite the moderation in price increases, a full 34% of analysts noted that prices charged have increased faster than unit costs over the past three months, the highest percentage since June. Furthermore, a full 61% said that margins are higher compared to a year ago at companies under their coverage. Luckily, our survey is in line with analysts on the Street: As of this Wednesday, Street analysts expected 61% of companies in the S&P 500 to have rising margins in 2006. S&P 500 earnings revisions have also improved, from 4.8% in early November to 7.9% this week.

We also asked analysts this month about the impact of lower energy quotes and higher materials prices on the bottom line. Lower energy prices will have little to no impact for 65% of the groups and will be a negative factor for the energy and utility companies. Higher metals and industrial commodity and foodstuff quotes will hurt the bottom line somewhat for 17% of the groups and significantly for 9% of the groups. Half of the analysts reported that these commodities have no impact on earnings.

Still, results from this month’s survey suggest that there is no sign of a revival yet, at least according to Morgan Stanley analysts. Along with the dismally low advance bookings index, our business conditions expectations index declined four points to 36%, matching September’s record low. This month, only one-fifth of analysts expect business conditions to improve over the next six months. Plans to hire and increase capex also declined in early December; 35% of groups plan to increase hiring over the next three months, retracing some of November’s record bounce to 41%. Only 43% of groups plan to increase capex, below the historical average of 46%. However, a full 45% of the groups that plan to increase capex plan to do so by 6% or more. We still maintain that there is pent-up demand for capital spending and expect that the deceleration in equipment and software outlays in 2006 will give way to roughly 7% annualized growth in the first two quarters of 2007.

The breadth of results narrowed in early December. 54% of analysts noted that conditions were unchanged over the past month, up from 41% in early November, while the percentage of analysts noting deteriorating conditions was only 30%, down from 41%. No analysts reported either noticeably deteriorated conditions or noticeably improved. Conditions improved for the consumer staples group and marginally for healthcare, while conditions deteriorated for IT, materials, industrials, financials and consumer discretionary.

On a positive note, the credit conditions index remained at 55%, indicating that financial conditions are still supportive of growth. We believe the decline in interest rates, the tightening of credit spreads, and the decline in the dollar have recently made financial conditions easier. We also asked analysts this month how much the declining dollar will contribute to bottom-line results at companies they cover. A full 41% said the dollar will have no impact, while 22% said it would have a marginal impact. The declining dollar will have a larger impact mostly for the consumer staples, IT, and materials groups, but will actually be a negative factor for the wireless services and railroads.

United States: Fiscal Outlook

Ted Wieseman | New York

After a flood of revenue growth that offset continued elevated spending led to a sharp narrowing in the budget gap in the past two fiscal years, we look for stabilization in FY2007, with revenue growth normalizing back towards GDP growth and spending growth decelerating to its slowest growth of the Bush Administration as tight budgets the past couple years take hold and gridlock rules in Washington. Net Treasury supply should rise relatively modestly this year, but with a compositional shift towards bills and away from coupons. Relative stability should rule through 2008, but the outcome of the 2008 elections and a sharp rise in maturing coupons in FY2009 create considerable uncertainty for the budget and Treasury financing beyond then.

Surging revenues drove another upside surprise in FY2006. With significant additional spending on tap for hurricane rebuilding and the beginning of the Medicare prescription drug plan and an expected moderation in tax revenue back towards the growth rate of the economy after the 14.6% spike in FY2005, we came into FY2006 expecting a significant temporary widening in the budget deficit to over $400 billion from the $319 billion recorded in FY2005. And boy were we wrong — revenues continued to surge, spending proved a bit more restrained than expected, with little growth on an underlying basis in nondefense discretionary outlays, and the deficit surprisingly narrowed significantly further to $248 billion, or 1.9% of GDP versus 2.6% in FY2005.

Total revenue jumped another 11.8% in FY2006, making for the strongest two-year rise since FY1980-81 (and with inflation running in double digits back then, the real rise the past two years was much stronger). Upside was seen across all categories. Individual income taxes rose 12.6%, with withheld taxes up 7.9% and nonwithheld 20.7%, the latter apparently reflecting in part the surge in options and bonuses that so sharply boosted Q1 wage and salary income in the national accounts. Corporate taxes jumped 27.2% and have now nearly tripled since the FY2003 trough. Social insurance taxes gained 5.5%. And driven by sharply higher remittances from the Fed, miscellaneous other revenues even spiked 17.6%. Meanwhile spending rose 7.4%. While this was in line with the elevated gains during the prior four years, on an underlying basis the results pointed to improvement. In particular, excluding defense, Social Security, Medicare (which was boosted by about $25 billion by the beginning of the prescription drug plan), Medicaid and other health programs, and net interest, spending rose 6.7% or $48 billion. Almost all of this reflected two special items — a $29 billion increase in spending by FEMA for flood insurance and other hurricane cleanup related spending, and about $15 billion in noncash accounting adjustments to revalue subsidies on student and housing loans made in prior years. Stripping these out clearly indicated that the tight lids on nondiscretionary budget authority passed in FY2005 and FY2006 finally started to take hold in a major way to restrain nondefense discretionary outlays — an underlying improvement that should be much more evident in FY2007 without the one-off boosts to spending.

Stabilization in 2007. We look for the deficit to widen modestly in FY2007 to $265 billion, which would keep it steady as a share of GDP at a relatively low 1.9%, with both revenue (+4.6%) and outlays (+4.8%) growth expected to moderate significantly. Relative to GDP, revenues plunged from a peak of 20.9% in FY2000 to a low of 16.3% in FY2003 before recovering to 18.4% in FY2006 — very close to the long-term average. We look for revenue to hold close to this share in FY2007, with growth expected to be just slightly less than our estimate for nominal GDP growth. This slightly slower expected revenue growth compared to GDP is largely from two sources. First, individual tax refund growth should be unusually strong relative to recent history in 2007 as a result of consumers’ ability to claim a refund of previously paid long distance telephone excise taxes that were overturned by the courts on their 2006 tax returns. This should boost refunds in 2007 by about $10 billion. Second, we are looking for a sharp slowing in corporate profits over the course of 2007. After rising at about 25% a year the past four years, we expect pre-tax corporate book profit growth to moderate to less than 5% in FY2007, and we also expect the effective tax rate to moderate slightly after a sharp surge in recent years. Taken together, we expect net corporate taxes to be up 4.0%. Otherwise, we expect withheld income (+5.4%), nonwithheld income (+5.9%), and social insurance (+5.2%) taxes together to run in line with our estimated growth in personal income, which we recently scaled back somewhat as we marked down our 2007 GDP forecast and incorporated the downward revisions to income in the last GDP revision.

The significant slowing in underlying nondefense discretionary spending growth that was seen in FY2006 should become more apparent in FY2007. This underlying restraint, the absence of special items that boosted outlays last year, and some continuing moderation in defense spending growth should help to offset upside in nondiscretionary spending — particularly Medicare and interest — to keep overall spending growth at +4.8%, which would be the smallest rise since FY2001 and a major improvement from average rises of 7.3% in the first five full years of the Bush Administration. On the upside, Medicare spending growth is likely to accelerate significantly further in FY2007 with the first full year of the prescription drug plan and a legislative change that shifted some payments out of 2006 and into 2007. Since the Medicare prescription plan picks up some costs that were previously covered by Medicaid, it makes more sense to look at them together — we expect overall spending in Medicare, Medicaid, and other health programs to rise 11.3% this year after rising 6.0% last year, accounting for more than half of the overall spending rise we project. Interest expense growth should moderate somewhat from the sharp surge seen last year as rates flatten out, but still see significant growth.

Meanwhile, on the positive side, discretionary spending growth, particularly nondefense, looks set to decelerate significantly. Since surging 16.3% in FY2003, defense spending growth has moderated each year since to +6.8% in FY2006, and we expect further slowing in FY2007 to +4.9%. After having surged 73% from FY2001 through FY2006, defense spending appears to moving towards gradually topping out at a high level. Meanwhile, after the spending spree of the early years of the Bush Administration, the White House requested and Congress passed tight limits on regular nondefense discretionary budget authority in both FY2005 and FY2006 of only about +2% in each year. And after a bit of a lag, this restraint clearly became apparent on an underlying basis in FY2006, even as overall spending was boosted by unusual items. Clearly, after the recent election the outlook here is somewhat cloudy for FY2007. With the outgoing Congress having passed only two of the eleven appropriations bills, the bulk of the budget is operating under a continuing resolution through February 15 that holds spending at last year’s levels. Our baseline case is that the likely gridlock next year keeps discretionary spending growth on a tight leash, as happened for an extended period during the Clinton Administration, which along with the continuing impact of the tight budgets passed the prior couple years should keep overall nondefense discretionary spending growth slow in FY2007. Adding in the impact of the absence of the special factors that boosted outlays in FY2006, we expect spending outside of defense, Social Security, Medicare, Medicaid and health, and interest to fall 2% this year.

Treasury financing implications. We expect overall net Treasury issuance to rise to $249 billion in FY2007 from $213 billion in FY2006. The $17 billion increase we expect in the budget deficit explains only about half of this. The rest should result from a smaller contribution from nonmarketable debt issuance and “other means of financing.” The combination of these two items reached a record +$103 billion in FY2005, and, while moderating significantly, remained very elevated at +$61 billion in FY2006. We look for some normalization to +$5 billion in FY2007. Nonmarketable debt issuance — which is primarily State and Local Government Series (SLGS) debt that municipal governments use as a means to invest proceeds from pre-refundings without running afoul of laws against their arbitraging the tax advantaged status of their debt — has already slowed sharply from a record $64 billion in FY2005 to $13 billion in FY2006. We look for a modest further slowing to $8 billion this year. The much bigger swing factor we estimate to be other means, which ran extremely strong relative to typical levels in each of the prior two years, as various off budget sources or uses of money turned significantly more positive. Our base case at this early stage is that these positive swings have run their course and other means will swing from a $48 billion source of cash in FY2006 to a slight use of money this year.

At current coupon sizes, we estimate Treasury faces a financing gap — the amount of increased market issuance through higher coupon sizes and net bill issuance needed to fund the budget gap plus nonmarketable funding sources or uses — in FY2007 of $97 billion. This — and any reasonably likely deviation from it — can be easily met within the current financing structure. The main shift we project in the current fiscal year is some rebalancing between bills and coupons. In FY2007 the first full year of revived 3-year notes will mature, leading to a $50 billion increase in overall coupon maturities. We expect coupon sizes to move somewhat higher starting with the 2-year and 5-year issues at the end of January and continuing with the February refunding and for these slightly levels to be maintained through year-end. We project a $2 billion boost in the 2-year size to $22 billion, a $1 billion increase in the 5-year to $15 billion, a $1 billion increase in the 3-year to $20 billion, and a $1 billion increase in the 10-year to $14 billion new/$9 billion reopening. Starting in February, 30-year issuance will shift to quarterly from semi-annual, with new issues in February and August and reopenings in May and November. We expect the run rate for 30-year issuance to rise from $24 billion to $30 billion ($9 billion new/$6 billion reopening), but since there was no bond in November, actual bond issuance would be unchanged at $24 billion in FY2007 under this pattern. Combined with an expected $70 billion in TIPS issuance, we see overall gross coupon issuance rising $20 billion to $698 billion, but net issuance falling to $190 billion from $217 billion. Offsetting this should be a pickup in net issuance of bills. The recent budget surprises led to net bill paydowns in each of the last two fiscal years and a sharp decline in the bill share of the outstanding publicly held debt from 22.4% at the end of FY2004 to 18.0% at the end of FY2006. The debt managers have suggested that the recent paydowns were neither intended nor particularly desirable and have seemingly driven the bill share below where Treasury would like it to be. The swing to about $60 billion in net bill issuance we project for FY2007, would start to rectify this, lifting the bill share about a half percentage point.

Medium-term issues. The Democratic takeover of Congress clearly presents significant uncertainties for the medium-term budget outlook. Our assumption is that not much of anything will happen for the remaining two years of the Bush Administration, keeping spending relatively restrained and the deficit near current levels as the trend like GDP growth we anticipate keeps revenue growth reasonably healthy. The key uncertainties will not be decided until the 2008 elections. The major Bush tax cuts begin to expire at the end of 2010, and unless Republicans hold the White House and retake Congress most of them likely will be allowed to expire. A Democratic sweep in 2008 would probably mean that the increased revenues this would bring in would be spent on programs the Democrats feel were neglected under the Republicans. A continuation of split government, in which tax cuts expired and not much in the way of new spending was able to get past the White House, could put the budget on a significantly improving path. As far as more medium-term funding issues, assuming the deficit stays reasonably close to current levels, the existing financing calendar is fine through FY2008. In FY2009, however, the first full year of monthly 5-year issues mature, leading to a sharp rise in coupon maturities and a large resulting financing gap that could possibly call for more substantive adjustments to the current auction schedule than the relatively small swings in coupon sizes and net bill issuance we expect for the next couple years

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.