The company adjusted EPS guidance for 2008-2010 based on higher expenses, reduced opportunities from patent challenges and the potential sale of its specialty business. We believe that the new guidance should be achievable and we have updated our model based on the guidance. The company expects to conclude the sale of its specialty business later this year - we have removed contributions from this segment from the fourth quarter onwards. We maintain a Hold rating on the stock.

The Merck Generics acquisition will allow Mylan to expand its footprints in non-U.S. markets like Europe, Japan and other Asia-Pacific regions. With Matrix and Merck Generics, Mylan should be able to position itself as a leader in the worldwide generics market.

The company expects to achieve synergies of $100 million, $121 million and $272 million in 2008, 2009, and 2010, respectively. Mylan shares are currently trading at 27.4x our estimated 2008 EPS of $0.50. Our price target of $14.50 is based on 29x our 2008 EPS estimate of $0.50.

Arpita Dutt, CA, contributed to the report.

Read the full analyst report on MYL

They state:

According to advance estimates released by the Bureau of Economic Analysis, U.S. real GDP growth was 1.9 percent in the second quarter of 2008. The contribution of net exports to U.S. growth was a robust 2.4 percent. In fact, net exports have partially offset the negative drag from private residential investment especially since 2007 (Chart 2), although this positive contribution could diminish as global growth slows.

The rest of the article is well worth reading. I'd like to just observe that the forecasts for RoW growth might have been overtaken by recent announcements regarding negative growth in Japan, incipient slowdown in the Euro Area and UK, and noticeable deceleration in some of the NICs [1]. Note that for US exports, the export-weighted RoW GDP is the more important.

In fact, a recession seems to be almost a foregone conclusion at this point since if we look at the recent messages emanating from official Japanese authorities, they are indeed bracing themselves for something ugly. Perhaps someone from the statistics department sent a primer of the Q2 GDP figures (due 13.08.2008) to parliament? I sure don't know, but the cabinet office recently released a statement in which the slump in industrial production and exports were used as impetus to argue that the cycle has now definitely turned. The secretary general of the ruling LDP party also chimed in as he notes how especially the economic situation en dehors de Tokyo increasingly resembles a recession. Shigeru Sugihara head of the Cabinet Office's statistics department also noted recently how the economy is very likely to have entered a recession. Finally Bloomberg connects the threads by suggesting that the Japanese economy may have shrunk -0.6% in Q2 after an impressive 1% showing in Q1. These numbers are built on the illusive median forecasts at this point but are indicative of what to expect. 

As per usual, this note will feature a look at developments in prices, domestic demand, industrial production (and exports) as well as the JPY. Obviously, the main thrust will be what exactly to expect in terms of the downturn; how serious it will be and how the BOJ and MOF will act. 

Cost-Push Thrust Continues - To the Consumers' Lament

Adding to the pressure on Japanese consumers, prices rose at its highest pace in June as the main inflation index clocked in at an all time high of 2.0%. Moreover, the US style core price index also managed to eek out a slight increase at 0.1%. This is the second time this year that the core of core index is in the positive but on an aggregate basis Japan remains in deflation.

As ever, the point to take away is how headline inflation from cost-push pressures not necessarily will lead to an underlying  effect on core-of-core prices. This is to say that it is difficult for companies to push forward cost-push inflation through the value chain in a situation where real wages are falling and where domestic demand, in general, is structurally weak. This broken link between headline inflation and core inflation and the congeniantly weak demand can be connected to the demographic profile of Japan. Quite simply, Japan does not posses the domestic demand to generate demand-pull inflation to any significant degree and this is reflected in the core-of-core index. Moreover, this is also why those much discerned second round effects are not very likely to materialise in Japan's context domestic demand dynamics do no support this as external demand slows.

Finally, this also underpins the lack of activity in corporate capex to spill-over into the domestic economy as so many pundits have been expecting during the recovery. It is important to understand the dynamics in this regard. As such, macroeconomics 1-0-1 tell us how to treat excess domestic investments over savings as a leakage which leads to an external surplus (otherwise S=I, and capacity for investments would be a lot smalle than is currently is the case). This rather mechanic perspective is important in so far as it shows us how activity in the corporate sector may be responding to external demand rather than domestic demand. And thus, we have the ensuing disconnect between industrial activity and domestic demand.

In light of the fact that oil seems to have peaked, for now at least, it appears that Japanese consumers not to mention companies may have experienced the worst of things. However, Morgan Stanley's Takehiro Sato seems to be less sanguine than official estimates from Japanese authorities. Alongside colleague Takeshi Yamaguchi he estimates that it will take in the region of 6-12 months for the current back drop in energy and food prices to have a material effect. This suggests that the cost-push thrust is set to linger throughout 2008 and perhaps some time into 2009.

Shifting gears over to consumption the Japanese consumer thus seems to have firmly caved in. With wages now falling, in nominal terms too, it does not take much of an economic literate to see that Japanese consumers are getting sandwiched at the moment. Wages in Japan fell back 2.9% (in real terms) in June and this marks a third consecutive drop this year. The meager evolution in wages has been a consistent feature of the Japanese economy throughout this so-called recovery. Yet, now that cost-push inflation is being added to the equation it is predictably feeding strongly into domest consumption expenditures, which still constitute the largest, if shrinking, share of Japan's GDP (55%).

It is now quite clear that domestic consumption in Japan is contracting and even though expenditures in June contracted less than in previous months the overall trend is one of a slump. Given the trajectory of real wages and inflation this is not particularly surprising but does mean that with external demand now also faltering, Japan is left without any kind of real growth engine.

As per ususal Ken Worsley provides the details of the monthly consumption report through which we learn how especially spending in durables and semi-durables contributed to the decline. If SY is right with respect to the lag in which falling energy prices feed through to the price indices it is difficult to expect a rebound in H02 2008.

Corporate Capex and Exports - The Final Dam Breaks

Perhaps the most significant snippet coming in off the wire since we last convened to look at Japan was the news that Japanese exports actually shrank in June on a y-o-y basis. Coupled with a rising import bill as a result of surging headline inflation, it means that the monthly trade surplus decreased a whopping 89% on a y-o-y basis [3].

If the level of Japanese exports is heading inexorably down, the trend in foreign demand composition is also interesting to consider. It shows that while a savvy Japanese export industry indeed did manage to decouple from the US or more aptly recouple to the big emerging markets, it cannot de-couple from the world. This is the nature of being dependent on exports and foreign asset income to grow. In this light, both exports to the US and Europe dropped at a hefty pace in June, the former being the 10th straight decline and the latter seing a second consecutive drop. Exports to emerging markets and not least China expanded, but at a much slower pace suggesting that the current account margin is narrowing. 

Yet, Japan's external balance is not only about exports.

In fact, the recent years' increase in Japan's positive external position owes more to the accumulation of foreign assets than to exports per se. This is also I point I latch on in my note on how Japanese savings, as a function of its demographic profile, will tend to go for yield.

In 2007, the net foreign asset position of Japanese savers (i.e. both companies and households) stood at around 250 billion Yen of which around 75-80% was made up of debt instruments. This makes up a nice cushion off of which to pull income. Add to this the currency gain as the continuation of outflows, due to the low interest rate environment, will tend to keep value of the Yen down (more about that below). I think it is important for investors to lock on to this trend as it tells a lot about global capital flows.

An additional point here would be that since the majority of Japan's foreign asset is in debt, the income flows will be less affected, from the credit crunch, than if it has been tilted towards equity (although one has to assume that asset income will go down with global growth). Obviously and depending on the kind of debt you own, defaults and yield obtained from securities you own and those you buy will depend greatly on where, and in what, you choose to invest.

Ultimately however, the point remains that as Japan external balance is now contracting, in relative terms, it will have a substantial impact on aggregate economic performance.

With exports faltering it should not come as a surprise that industrial output and capex are also slowly but surely trending downwards. On a m-o-m basis production dropped 2.8% and on a seasonally adjusted index (see this graph) it appears that the high levels of the latter part of 2007 are now replaced by one of those famous lower plateaus. In a quarterly perspective, it can also be seen below how the cycle now seems to have turned.

Judged by forward looking indicators and production assements, it appears that the first two quarters of 2008 may well have seen a q-o-q contraction of industrial output. However, it also seems clear that industrial activity may have a long way to fall as it enters the current correction with a lag. Especially the likely reluctance of external demand to reach hitherto heights will make it difficult for Japanese firms to build up production. It would subsequently mean that production plans will need to be further downscaled. 

Sato and Yamaguchi (SY) field some pretty grim numbers for the potential course of industrial activity and manufacturing. They consequently forecast, based on information from previous recessions, that total output may have to come down as much as 6%. SY also indicate that the recent Tankan survey may have been too optimistic in its top line outlook. Should this turn out true, production assessments will have to be further cut.

There is still however some disagreement on the actual outlook here. Bloomberg consequently features a more sanguine analysis in a recent article. The point would then be that forward looking indicators in the form of equipment and machinery orders declined less than forecast. This might be true in so far as goes Bloomberg's own meadian forecast but I think it is quite difficult to see anything remotely positive in the incoming figures. Whether the incoming slowdown will resemble the 2001 recession is another question of course, but at this point I think that it is also an irrelevant one.

The JPY - Macrofundamentals to Take Over?

With the recent turmoil surrounding the near bust of Fannie and Freddie Mae many FX punters would perhaps expect it to be a sure bet to buy some Yen crosses. Consequently, more than notional evidence has suggested how traditional carry trade crosses (CHF and JPY) have been negatively correlated with risky assets. In times of market turmoil and volatility, the only thing a savvy currency trader thus need to do is to pile up on JPY and CHF longs as she was betting on the unwinding of short term highly leveraged carry trade positions. If it was ever so easy.

I am unsure as to whether the correlation is broken entirely, but it is quite obvious that is has weakened significantly in the past two months. As such and while I would still expect the JPY to react on extreme risk aversion two other factors are at work. The first, I think, is related to the recent drop in headline inflation from oil in particular. Not only has this boosted the USD across the board and by derivative the USD/JPY, it has also provided a cushion for stocks and other risky assets. This story has been roaming financial market punditry for the better part of the last month, and suggests the importance investors ascribe to the adverse effects of inflation.

The other factor is more structural in nature and relates to the points made above on Japan's positive income balance and net investment position. In this way, Japan quite literally needs to ship its capital and goods abroad in order to grow. This is a simple reflection of the country's demographic structure and subsequent low domestic interest rate environment. This decline in home bias can thus be considered a lingering structural trend, as it effectively links up with Japan's demographic profile[2]. The conclusion is consequently that the JPY is set to stay weak and steadily weaken against its trade partners. This would apply for the level of the JPY in particular.

If we add the fact that exports of goods and services are now actually falling and the terms of trade shock from a high oil price, the immediate outlook is for further JPY weakness. 

Obviously, I still owe somewhat of an explanation since when does one effect take over from the other?

My immediate response to this question would be that an increased decline in home bias, low domestic interest rates, and the subsequent steady outflow of funds (and goods and services) will dominate and keep the JPY down. In this way, I do not deviate much from Stephen Jen with respect to fundamentals. Yet, this is also a discussion about the nature of capital flows. In this way, the fundamentalist view would hold that the JPY is being held down by plain and simply unlevered outflows or more aptly; diversification out of Japanese risky assets with respect to the market portfolio.

However, there is another perspetive too. If the low JPY is primarily driven by carry trade positions and levered bets against the uncovered interest rate parity it would make sense for the JPY to be sensitive to reversals in the market. This indeed has been the focus of many articles and op-eds over the course of credit turmoil and beyond. For example, we learned recently that the number of margin trading accounts in Japan has now exceeded 1 million and that the funds attacted to these accounts rose 13.5% y-o-y totalling 6.3 billion USD. In this context, the actions of Ms. Watanabe and other savvy Japanese housewives represent an important case in point. Of course, with the recent change of tact in the Aussie and the Kiwi (at least against the USD) one has to wonder whether in fact the fundamentals of the trade is changing, if only for a while.

I will forgive my readers if the conclusion may be a tad bit difficult to discern on this topic. As stated, I hold the view that outflows (levered and non-levered) will continue to keep a lid on the JPY's appreciation. However, the extent to which the JPY will react on sudden spurts of volatility is still something to be aware of, and is likely to depend on the level of levered carry trade positions.

A Recession it is Then - So, What About Policy Response?

I think that SY manage to pin point the situation quite neatly when they note how Japan lost two engines in Q2 2008; personal consumption and exports. Of these two, the latter will by far have the biggest impact since in the case of the former, it never really got past first gear during the present and so-called recovery. 

SY roll out the big forecasting kit in their attempt to give an impression of when Japan's economy may hit the trough; with the assumption being that it peaked in Q4 2007. The conclusion is that Japan is set to hit bottom in Q1 2009 after which it will steadily pick-up. There can be no doubt that this argument is solidly built upon historical performance measures. However, I don't think that the recession as such is the major news point here, in the sense that such things come and go. The key for me is the regularity by which recessions have hit Japan since 2000 and the subsequent nature of the "recoveries". In this way, I am not expecting a recovercy as such, in the sense that unless exports find a new decisive foothold towards external demand, Japan is likely to limping ahead very close to a zero growth rate.

This brings us neatly over to the policy reactions from all this.

Obviously, with growth now slowing the quants in the treasury are being forced into revising their revenue models. Specifically, the objective to balance the budget by 2011 may now be nothing but a good faith declaration on paper with no real bearing towards reality.  One immediate consequence here is obviously that issuing more sovereigns to finance government spending is out. In fact, with a public debt/GDP ratio close to 170%, any faint muttering as such would be sure to prompt the rating agencies into attack mode.

Moreover and as per usual, the prospect of increasing the incoming consumption tax is rearing its head. In May, Economics and Fiscal minister Yosano, from the LDP, consequently suggested that Japan double a planned 5% consumption tax by 2015. No one can deny that the government's top line needs additional input, but it is also important to understand that levying tax on consumers will only further solidfy Japan's growth path whereby domestic demand stays weak and the economy relies on exports to grow. There is nothing wrong with that per se. The problem however is that export dependency will become a structural tendency for many economies during the next decade so Japan will finds its growth strategy more crowded as we move forward. [4] 

Regarding monetary policy, the BOJ held rates steady during their last convention and is widely expected to maintain this stance for the forseeable future. SY are fiddling with the BOJ moving in with a 25 basis point cut in Q2 2009. I am not willing to look that far ahead. Given the already low level of interest rates anything short of a sharp backdrop into deflation or a very severe slowdown would not justify, I think, a move back towards ZIRP.  This may happen and the data should be watched closely in this regard. For now however, I am sticking to my guns that the BOJ is likely to stay on hold.

Notes

[1] See the following notes in particular; Japan - Still Fighting off the Recession; When Will the Strength Ebb Out? and Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

[2] See this note and also Morgan Stanley's Stephen Jen (here and here)

[3] See this chart

[4] See further points on export dependency here

Disclosure (c.f. Seeking Alpha agreement): Trading out of a monopoly money account with the following FX positions: short AUD/USD, short NZD/USD, short EUR/USD, and short EUR/JPY.

[Update: Brad Setser clarifies, in the comment section, his view on Sender's FT piece referenced below]

THE last week (or was that year?) has certainly been something of a ride hasn't? In fact, I thought it would be apt to reproduce this picture by the brilliant KAL who normally spices up the Economist with his imagery that lay serious claim to the adage that a picture tells more than a thousand words. This particular specimen and the ensuing headline were on the front cover in October 1997 when markets also took investors and observers for a roller-coaster ride. I think it is quite fitting in describing the feeling many a trader and market participant must have at the moment.

Even though it could only seem as a few days ago that the credit turmoil went global with BNP Paribas' announcement that it too would be suffering subprime related write downs it is actually almost a year ago. Actually, if you use the same yardstick as I have tended to apply, the first of August will see the one year anniversary of one of the worst global financial crises (arguably) since the 1930s. The ever readable Martin Wolf (from the FT) expresses a similar sentiment in his most recent column. What is more, Wolf makes the point that we may not even have seen the end of the beginning yet. Adding to the gloom, I tend to agree with this.

Concepts such as bear market, stagflation, bailouts of tarnished financial companies, increased market volatility, and housing market busts have thus all become ingrained in investors', regulators' and not to mention central bankers' vocabulary as of late. Personally I think that we may soon add deflation to the list but more on that below.

Where Art' Thou My Fair Market?

If we begin at the first group it has not been an easy game to play; to say the least. Sure, commodities have been a solid play and in general the tendency has been one of wealth destruction in the context of risky assets as most international equity markets have seen near bear market conditions. I hear that real estate projects have been quite sluggish too. But in the current environment and given the amount of volatility, any leveraged position, in any asset class, firmly in the black one day could have easily been subjected to a margin call the next.

One excellent window into the daily workings of the market place is of course our devoted and popular Macro Man who never tires of sharing his insight with the rest of us. Usually, MM massages several topics but one interesting theme passing on his blog recently has been the difficulty with which investors, even the pros, have had exercising their hand. Consider thus the following point made by Macro Man;

As observed a few times over the last week or so, Macro Mas has found trading conditions evolve from pretty relaxing to downright terrifying at times. He's found it pretty easy to second guess every trading decision he makes, often after only a few minutes. That's an urge that he is trying to fight; in all conditions, but particularly when it gets a touch difficult, it's important to look forward rather than back.

In any event, it doesn't take much digging to confirm that conditions have been tricky, and that Macro Man hasn't dropped 50 points of trading IQ since the 4th of July. Consider that over the past 10 trading days, a period in which the SPX has dropped 5.1%, no less than seven of those days have witnessed an intraday rally of at least 1.5%. Unless one is a brilliant intraday trader- and Macro Man is not- this sort of market naturally lends itself to trades that have a, ahem, "suboptimal P/L impact."

In his examples Macro Man uses the SP500 as the main example of the adage that not only the almighty but also, it seems, the market sometimes moves in mysterious ways. These points and not least this graph fielded incited me to have a look at the intra-day volatility of the SP500. The ensuing results confirm the remarks above.

The first graph shows an implied version of volatility during the entire subprime turmoil period. As can been the past weeks have not, on the face of it, been extraordinary. Yet, if we look at intra-day volatility over the past month one can easily see the message conveyed above. The sample period in question can of course be debated ( for the short term frequency graphs I have opted for the same as Macro Man) but it is long enough the prove the point. As such and even though the trend in SP500 has been inexorably down there has been some significant spurts (or as some would call them sucker rallies) along the way. In fact, if we look at the intra-day volatility we see that a good number of spikes above 2% both with respect to the difference between high and low as well as open and close values.

In a general sense and with the distinctly execrable economic environment in the US one should also have expected more action in currencies. This is especially the case with respect to the EUR/USD that has not, despite a faint inclination, managed to break decisively above 1.60. Not unlike neglecting to change gears as you race towards the rev limiter the EUR/USD has been bouncing off against the 1.60 mark and then down again to 1.585ish. Perhaps this has more to do with the stock market than anything else as the USD moves closely together with equities through its correlation with oil; with an inverse relationship of course. In light of the point made above on the 'on-off' nature of equity markets it may just be that the USD is finding it difficult to choose a direction. One thing is certain then; there does not seem to a magic barrier surrounding the 1.60 mark but as long as the market chooses to believe in various rescue packages and the (final) inclination for the Fed to go for inflation it is unlikely that we will see a violent rally.

The latest earning reports have been a bit mixed with a significant addition to the Butcher's Bill by Merrill Lynch over to the less than expected write-off by Citigroup. I will let the gun-slingers of the world markets discern these reports but I definitely think that momentum in equities is down since the slowdown, at this point, is far from over. Although, one has to wonder whether signs that oil prices may be heading down will also provide support for equities in the immediate future. Sean Maher thinks so for one. The main point as can also be derived from the plight expressed by Macro Man would however be that even though you have the overall trend right, you should not leave you trading screen for more than a whee coffee break less you wanna be pulled down by a quick reversal.

Revisiting Old Arguments?

Now, this is obviously not only a story about market volatility which can thus be seen as a derivative of a much wider issue in financial markets and with respect to the global economy. More specifically it is a story about the global economy, its structure through capital flows, and the sustainability of these. In this light, a couple of important new themes have emerged lately while some old ones have been intensified.

On obvious lingering theme is the continuing weakness of the US economy and financial system which is not only sending ripples through the US society but also the global economy. As you can imagine the econsphere and media in general have been absolutely buzzing with the recent shot across the bov in the form of the debacle of Fannie and Freddie Mae. A good place to start would be Tyler Cowen who provides a good overview of the initial flurry. RGE's Finance and Market monitor which has virtually been turned into a Fannie/Freddie Mae watch this week is also a good place to; I would especially highlight the following two from James Hamilton. Also, Thursday's edition of Morgan Stanley's Global Economics Forum features a fine re-cap by Richard Berner and David Greenlaw. Finally, the Economist's print edition just fresh off of the publisher also devotes a fair amount of pages to the issue at hand.

Obviously, even after churning through the pages linked above you would hardly get that illusive "big picture". It is certain that the Fed, in conjunction with the Treasury, have rolled out the big guns in order to ensure that Freddie and Fannie do not fail. So far it has worked, since even though the shares have plummeted the debt outstanding in the form of agencies have not. This is what was initially the intention I think since a crash of the agency market would have been catastrophic.

One particularly interesting aspect here is obviously the fact that a fair part of the financing of the US external deficit and by derivative its mortgage boom was done through purchasing of agencies by foreign central banks and state investment vehicles. The link to the USD peggers are brilliantly exposed by Brad Setser as he estimates that China alone holds anywhere between $500 and $600 billion in agencies or roughly 10% of the outstanding stock.

The functioning of Bretton Woods II and the collective bet on the US consumer of last resort is well known. As such and since the external deficit in some ways has been fuelled by the financing of the housing boom it would only be natural to expect that as the debitor struggles so does the creditors. Well, unfortunately this does not seem to be the case. I say unfortunately here since the devil in me (and although I know this is not really an option) would have no problem seeing US creditors taking part of the hit from this; i.e let those bonds burn if that is what it takes. Consequently, I had to shake my heads several times when I read some of the initial reactions by foreign holders of agencies as conveyed by one of Michiyo Nakamoto's recent pieces in the FT. Consider example the following tidbits:

The Financial Supervisory Commission (FSC), Taiwan’s regulator, said the market reaction had been driven by fear rather than fact, pointing out that the US lenders’ federal backing made their debt quasi-governmental.

(...)

“We believe that the impact on Japanese banks [of their exposure to the government-sponsored enterprises] is minimal since they do not own equity,” Hironari Nozaki, banking analyst at Nikko Citigroup, said in a report yesterday. The default risk of the GSE bonds that Japanese banks owned was extremely small, he said.

Now, let me be clear that I don't really think that Paulson and Bernanke could have acted otherwise here (well, the banning of "naked" shorts is another matter) but what a royal mess we have on our hands. It is hardly a wonder that some, in the current environment, are musing about the credit worthiness of the US government all together. Obviously, this has a whiff of theatricals about it, not least in a context where one major rating agency recently downgraded India at one and the same time as Japan is upgraded (recently) and Italy maintains its rating. Anyone with a definition of "economic fundamentals" ready at hand?

In a more structural perspective the FT (and here through Reuters) also ran story well in line with current sentiment as it suggested how the big players amongst the sovereign wealth funds and central bank authorities were seriously considering to diversify away for the USD. This is hardly news as these stories have been surfacing in regular intervals since the subprime turmoil hit global markets. Given the y-o-y slide in the buck it is difficult not to put more than a little bit emphasis on this story but to me it is also somewhat of a smoke screen. As such, I wholeheartedly agree with those who believe that the Bretton Woods II is due to a revision. However, so far I can only see one strong impetus for this and that is the obvious need for the US economy to get the house in order and reduce the twin deficits. Recently quarterly reports on export contribution to US growth are good news in this regard. The other part of the equation however is still somewhat missing.

The question we need to ask is thus the extent to which the USD peggers can actually turn the ship around at this point ... you know, with respect to becoming consumption driven and all. More to point and if we accept that the US should be replaced by another economy or a group of economies it is not straight forward, at this point, to see where the candidate(s) are.

With respect to the illusive concept of diversification I rely on the principles of the comparative advantage and thus the work by Brad Setser and Rachel Ziemba. The former massages the above mentioned article posted in Reuters and unlike what you might expect he does not latch on to the fact that Gulf states are reducing their exposures to the USD (he already knows the data by heart I imagine). Rather, Setser points out the growing discontent of reserve asset managers with their investments in Europe and the US.

But perhaps the most interesting part of Sender’s article is the part suggesting that the United States’ creditors are increasingly frustrated by US policy — and no doubt also unhappy that their investments in US (and European) financial firms have performed so poorly.

The fact that this frustration is starting to spill over into the press is news. My guess is that a lot of funds are down significantly so far this year, and in some cases the falling value of their existing portfolio may be a big enough drag to nearly offset all the new oil inflows.

Regarding the prospect of some kind of USD crash I still think we need to keep our heads decidedly cool. My feeling is thus first of all that we need to tackle the extent to which we are past a point of no return. The extent to which we will see significant diversification (or depegging) therefore rests on two important obstacles in my opinion. First of all there is the question of what SAFE et al. should diversify into and whether the 'recipient(s)' would accept this? Surely, the Euro is heading for more than a bit of problems in the years to come which will make it quite clear that it cannot take up the baton for the US. Secondly, many SWFs and central banks WOULD have to incur loses on their remaining USD holdings if they decided to bury the buck. All this does not mean that we won't see diversification at all; to put this as an argument would also be somewhat of a reality defying argument. My only point would simply be that the process will not be a linear one in which the Euro takes over from the Dollar and therefore that old notions of de-coupling and rebalancing need to be taken with more than a pinch of salt.

As a final point on this, the hunger with which the recent Fannie/Freddie offerings was munched suggest, at least initially, that it is all back to business as usual. Note here that 61% of the issue was picked up by investors outside America apparently content with the higher, government backed, yield over treasuries.

To Inflate or Deflate?

If the credit crunch began with a fear of growth and damage control it has since shifted into a focus on the adverse effects from inflation. Especially, the nexus made up by the pressure from headline inflation fuelled by a weakening Dollar over to the ensuing pressure on risky assets have been much under scrutiny. In fact, it would not be a long shot to say that the graph below pretty well sums up the market's response to the credit turmoil.

The focus on inflation is understandable and important not least in the context of indications that inflation expectations have been edging up. Much debate has been devoted to the extent to which global central banks are really serious when it comes to focusing on inflation at the same time as the economic edifice is crumbling. Of course, in emerging economies such as for example in Eastern Europe, key parts of Asia and Latin America inflation is a very serious concern as many of these economies are quite literally burning up. But how much can higher domestic interest rates help here? In a world where capital goes for yield, inflation targeting by one central bank will not work if the rest of gang chooses to go for growth. Moreover, there is the delicate point with which to balance the need for emerging economies to see nominal appreciation of their currencies while avoiding to become to the new global consumer of last resort as the hot money comes flowing in. China is almost a perverse example here since, while there has been no official mutterings about a revaluation money is coming in fast on the expectation that inflation ultimately will bring the USD peg to its knees (see nice discussions here and here). In India and Brazil policy makers are wrestling with the same problem as the attempt to keep the economy balanced conflicts with the need to do something about inflation. There are no easy solutions here it seems.

In an immediate policy context, there is also a lot of sentiment flying around I think. Lowering interest rates to cushion those who should not be cushioned and, in turn, submitting the global economy to a heavy yoke of inflation is thus not popular. Bernanke and Paulson are certainly making themselves distinctly unpopular in some parts of the investment community as they have chosen to respond to the crisis by supplying ever more liquidity. But could they have done anything else?

As I have argued before it is rather funny to see the US being branded the scarlet letter of the global excess liquidity source. The point here would be that it was only 1 and a half year ago that this role was assigned to Japan and since the BOJ has not exactly managed, with great force, to shed itself of the low interest rate policy it is difficult to see whether anything has materially changed? I shall be the first to admit that excess global liquidity is a problem and that this problem to a large extent is at the heart of the current mess. However, I would also wish that more people tried to connect the dots in a slightly more sophisticated way than to blame it all on Greenspan and Bernanke.

Ultimately then, this is first and foremost a debt crisis coupled with a search for assets to match the structurally persistent availability of excess liquidity. Thus, it is also important to understand that as we are about to enter a significant bout of asset destruction and while at the same time providing more liquidity, the global yield game is likely to intensify. The debt problem and the subsequent need for many economies to significantly tighten the belt and ramp up savings is a key trigger effect here. It means that the effects on the real economy may well turn out to be deflationary in the context of some economies who simply do not have the ability to propel internal demand at the same time as turning the ship around towards more focus on saving. If you doubt me on this I suggest you take a look at Spain and quite possibly also Italy, Germany and Portugal; not to mention key economies in Eastern Europe but that may be further into the future. In the end this is also why I have been persisting in my focus on the distinction between core and headline inflation; In for example Japan (top graph) and the Eurozone:

The figures obviously do not indicate that core prices are not rising since in many economies they are; and fast too. The point I would like to emphasise here is simply the asymmetries by which the current crisis may unravel with inflation continuing on a global scale while some countries risk falling into a Japan like deflation trap, out from which it is very difficult to escape. My hypothesis is furthermore that countries with a weak demographic profile will be in the front line as potential candidates to see persistent and ongoing deflation. In a Eurozone context I have been particularly adamant in pointing towards this risk since it is quite clear I think that the ECB would find it very hard indeed, if not impossible, to administer some variant of ZIRP in the context of one country. And then we have not even talked about the effects any provisional liquidity arrangements would have on the Eurozone's countries' relative sovereign debt standing.

So far the market discourse still seems set on inflation even if the recent near collapse of the two US mortgage giants have moved the focal point a slight bit. Moreover, and as is visible in the graphs above oil has recently taken a dip which is prompting many to ask whether the current rally is, if not coming to an end, easing slightly. In-house RGE analyst Rachel Ziemba asks the same question while Paul Krugman and Stefan Karlsson chimes in. I tend to agree with the sentiment expressed by these contributions and while it is true that oil may sell off it is difficult to see a plunge. I think there is a considerable hysteris effect in operation here (in the long run) with respect to commodities in the sense that they are much more elastic to the upside than to the downside. In the short term of course it may be well be the opposite case. 

My main point would simply be however that there is very little central banks can do about this. In fact, as can be seen from the recent Eurozone trade data flogging the Buck has not helped with that distinct problem. I would also add that we should never forget how rising costs of primary goods could ultimately add to the deflation pressure due to the cross price elasticity with core consumer goods. The key for me is the extent to which a given economy is able to muster the sufficient domestic demand to avoid seeing deflation in its domestic market if the going really gets tough. Italy, Spain, and Germany for example may not be able to do this.

Faint mumblings are consequently also beginning to move the focus from inflation to deflation/growth. In the Eurozone where the ECB managed to sneak a last minute raise past the post Trichet is bracing for a recession in the next two quarters which effectively means that the ECB's hands are tied. I also noted that the D-word was mentioned in a Bloomberg headline recently as Société Générale's Albert Edwards, among others, was quoted saying that deflation may be the next story to watch out for. Michael Mandel makes the same observation predicting that the next story on prices will be deflation. I hardly think that this would be a surprise. Personally, I am on record for flagging the deflation flag for quite some time and while it has nothing to do with complacency against inflation or me being an apologist, it is simply a question of adequately balancing the risks.

One Year In ... Still Some to Go

Almost one year into the credit crisis the hard truth remains that we are not near the end of the road. Things are likely to get worse before they get better.

In this note I have dealt with a couple of themes. Firstly, there is the strict market perspective where fundamentals and trading models are being revised by the day. As I noted, I do think that we need to see some volatility in currency markets soon, but in what direction obviously remains the key question.

More specifically, I have also re-visited old arguments and not least in the context of the much tarnished BWII edifice. In many ways, one could argue that it already has crumbled or at least changed significantly. It is consequently quite clear that the US decisively has signalled the unwillingness to act as the future anchor, effectively pushing the decision over to the USD peggers who are finding it more than a bit difficult to contain inflation while at the same time staying pat with their currency policy. Given the extent to which emerging market and BRIC central banks are willing to intervene it is very difficult to envision some kind of rapid move. All this has so far handed the Euro with the dubious honor of taking over from the USD. This is not very likely to be sustained, but when that is said it is also hard to see how the EUR/USD could suddenly move back into the 1.20s. The need to correct a US deficit and rebalance the US economy will mean that Trichet et al. WILL need to pay off their strategy with interests.

In a similar vein, I have emphasised the need for economies such as Brazil, India, and Turkey to accept their potentially new role in the global economy. If they do not, we will simply have too many exporters relative to importers and even if these three do not go mercantilist there will still be too much savings going for too little yield. This is still the ultimate nut to crack in the global economy and the sooner we realize that demographics have something to do with it the better.

Finally, I also noted how the discourse perhaps slowly is beginning to nudge back onto growth and, if core inflation remains subdued, deflation. So far, this is not the case but it is a narrative important to watch I think since it may change quite quickly.

Post Script

Here at the end of my note I would like to feature (or present as it were) two pieces which I enjoyed immensely reading but never really got to comment on; an omission which I am sure my readers will excuse given the sheer amount of pundity being posted on the internet. The author is one Cassandra who, apart from doing Tokyo on a regular basis, recently returned from the soothing calm of Tyrol in Italy to resume services. 

On a side note I would not be going out on a limb, I think, when I say that Cassandra, together with Macro Man and the olive producing Charles Butler make the econsphere a distinctly better place to be. The reason for the grouping of the three might seem odd at first but if you read carefully and stay with them for a while you will see that they manage to combine succint observations and deep financial knowledge with excllent writing; a combination I value greatly.

Anyway and to move things back on track before this turns into a fan letter I thought that the following pieces by Cassandra were very much to the point with respect to (attempting) a lateral cut through this whole mess in which the economy and financial system finds itself.

Liquidity Tug-o-War??

Notes To Self - End Q2 2008

A belated plug I know, but still much worth a closer look.      

Especially, the last event prompted me into action as I decided to have a closer look at the Danish economy and where it might be heading. In many ways Denmark is similar to other credit crunch struck economies not least in the context of experiencing a severe unravelling of a housing boom. As we saw last week this is now beginning to have collateral damage. Yet, Denmark is also a bit different not least because the economy is going into this crisis with a positive balance both on the public but also ever so importantly on the external books. 

My note is up on Global Economy Matters and here it is as it is presented over at that space; please click on pictures for better viewing; oh and sorry for not formatting them to Alpha.Sources' template.

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Stagflation, credit crunch, bank bails-outs, and housing market busts are all concepts that are unfortunately now becoming all too familiar to the current Danish economic discourse and indeed even to the Danish public at large as they read their morning paper over breakfast, or listen to the radio on their way to work. And not of course in their United States version, but rather in their homegrown variant. But just how serious is the construction and banking problem in Denmark?

A quick initial glance at the short term data definitely suggests that a serious batch of storm clouds may well be gathering above the economy. Not only did Denmark claim the dubious honor of being the first economy in Europe to exhibit a technical recession but it was also recently handed its very own banking crisis à la Bear Stearns and Freddie/Fannie, since only last Friday the 10th largest bank, Roskilde Bank, had to go hat in hand to the central bank for a provisional liquidity guarantee as the writedowns it was about to announce to the market were judged to be too tough to swallow without risking a bank run.

However, things in Denmark need not be as serious as that initial glance might suggest, and, at this point at any rate, I would most definitely not group Denmark together with other European economies - Spain, the UK, Ireland - who who certainly seem to be facing a very tough time indeed moving forward. On the other hand, I think it is reasonably safe to say that things in Denmark will almost surely get a lot worse before they get better, and really the key question is not how deep will the recession be, but what will be the structural characteristics of the economy which subsequently emerges?


So in the analysis which follows I will attempt to answer this question question through an in-depth look at the Danish economy, where it is, where it has been, and where it is about to go.

If we start at the beginning, with headline GDP growth, it is easy to see the extent of the recent slump of the Danish economy.

As I will explain below one of the key drivers of the recent Danish consumption boom has been the upward march of house prices. Now that higher interest rates and rising energy costs are rolling in at the same time as the housing boom gets well past its peak it is only natural that consumers are scaling back. Danske Bank analysts however (the only link is in Danish I am afraid) are fairly sanguine when it comes to their assessment of the Danish consumer. They limit themselves to pointing out that when compared with other "property driven" countries such as the UK, the US, Norway and Sweden the increase in Danish consumption has not been that outstanding. I think such comparisons are - by their very nature - rather spurious. The main point we need to think about is not really the relative strength of the Danish consumer but simply how much in absolute terms we expect consumption to be a drag on growth. In this respect I tend to agree with Danske Bank that it is unlikely that consumption will plummet completely. This is true, at least, in terms of the immediate outlook where an extremely tight labour market will support consumption in the sense that people still have a steady income to spend from. Yet, the credit crunch following the subprime turmoil has not passed the Danish doorstep without paying a visit. The recent quarterly report by the Danish central bank elaborates on this in great detail. Especially chart 11 (p. 20) offers a nice perspective as it shows the year on year trend in lending growth which is inexorably moving down even if the growth rate is still positive. As a final point, Danske Banks points out that real income is still climbing if we deflate the wage bill using core prices only.

Ultimately, my feeling is that it is still too early to call it on the consumption side. The outlook is clearly deteriorating though, and consumer confidence is slumping. Much will depend on the extent to which the labour market softens in the coming quarters (and indeed years). Apart from this, the degree of the unravelling on the housing market boom and the extent to which lending institutions tighten credit standards and lending conditions will obviously also be important. Danske Bank is looking for an increase in consumption at about 1% y-o-y in 2009. Given the outlook on lending and housing I would say that Danske Bank is perhaps rather optimistic.

While it is still a bit too early to say whether consumption will drop down through the floor and descend into the basement, it does seem clear that investment is now heading into a decisive slowdown.

The very impressive recent investment performance by Danish companies - which formed the backdrop to the recent expansion - is by now pretty well known. A tight labour market and low interest rates have consequently provided Danish companies with ample reason to invest. This coupled with residential investment that has been literally booming has meant that investment was a strong driving force in the Danish economy. From 2001 to 2006/07 residential investment increased from 3% of GDP to 7%. All good things must come to and end however and it seems clear from the above graph that the trend is now much more modest and even possibly back stepping in the form of contraction. If Danske Bank are correct in their assessment of fall in residential investment to the tune of about 2% in 2008 this will be a significant drag on aggregate fixed capital formation.

Moving on to the public sector we find one major advantage for Denmark going into the coming downturn, since Denmark has been running a very healthy surplus on the public books to the tune of 4.4% in 2007. Moreover and as can be observed below Denmark is trying to be the proverbial top of the class EU student by bringing down public debt quite dramatically over the past decade.

Finally, if we come to look at the external sector we find another of the defining factors that separates Denmark from many other credit crunch struck economies.

The main point would be that even though Denmark has been ramping up consumption to a significant degree this has not lead to a deficit on the external books; even if recent quarters have seen the balance edging slightly into negative. This relatively healthy position, when taken with the situation in the public accounts, is obviously quite important. What we seem to have here is a picture of an economy that has not, on the face of it, been living beyond its means.

One important point to take away from all this I think is the idea that Denmark may be benefiting from being a small open economy situated near the apex of the global value chain. This should then translate into the fact that at any given point in time what goes out adds more value than what goes in, making it "easier" to sustain a positive external balance even if the economy is operating near full capacity. In a cyclical perspective however, there is reason to believe that with the recent surge in the Euro - and by implication the Danish Krona which is effectively locked into it - the positive balance will be more difficult to sustain in the immediate future. This would be certain to bring all kinds of ghosts forth from the past as it was exactly a ballooning external deficit which prompted the Conservative government in the 1980s to instigate the, among Danes now famous, Potatoe Treatment which was a quite harsh bout of fiscal contraction aimed at halting domestic consumption and putting a lid on housing and residential investments.

If the above charts and narrative sketch out the immediate state of play with respect to the Danish economy it could still be argued that I am missing one important aspect of the situation, since Denmark, like the rest of the world, has also caught the stagflation flu which seems to be going the rounds of the global economies right now. And just to prove that it isn't always different, Denmark's inflation is now running close to the 4% mark at one and the same time as the economy is slowing significantly.

As with the general global picture, the increase in prices is coming almost exclusively from headline pressures but many domestic economists would also point towards the fact that the failure to prevent the Danish economy from bumping up against its capacity limit will exacerbate the incoming downturn. However, if we really want to get down to business with respect to the recent performance of the Danish economy, and its immediate outlook, there are two sectors which are absolutely crucial. One is the labour market (and the associated demographic profile of Denmark) and the other is the housing sector.

We Don't have Subprime Loans in Denmark, Or ... ?

Moreover, it is very important, in a Danish context, to latch on to the crucial importance of the Copenhagen region in the whole housing discussion. Basically, and while both total turnover and prices are declining on a country-wide basis, the correction in Copenhagen has been particularly severe. This is important because the Copenhagen region naturally commands a crucial position in terms of wealth and income concentration in the Danish economy. Particularly noteworthy has been the extent to which apartments have seen a correction in prices. The situation is now one of a quite serious mismatch between the supply of housing and demand side capacity to absorb it. Obviously, everything has its price and while I have faith in the dynamics of supply and demand the key is the extent to which this price will allow existing owners to actually repay their mortgages. So far, this talk about "technical defaults" is only a fringe discourse but the longer prices fall the more this problem will grow I think.

We also need at this point to consider the relation between house prices and consumption. In overall terms, there are two ways in which we could do this. One is through a traditional academic type discussion about the so-called wealth effect in the context of home price appreciation and whether this link has been strengthened by creative credit products and, as a consequence, the ability to tap mortgage wealth for consumption. The second would be a more subtle point about the link from housing/construction to the banking sector and thus over to tightening credit standards for companies and consumers. This after all is what the lingering credit-crunch mess is all about. Roskilde Bank for example is an important warning shot across the bow in the sense that it was exactly an overly lax lending strategy towards construction/real estate investors that brought the bank to its knees last week.

At the end of the day the vulnerability of the Danish economy to a housing downturn basically boils down to the extent to which Denmark has been drinking the subprime cool aid in some way or another. Danish bureaucrats would almost certainly frown at such a suggestion, and point to the key institutions in Denmark; the so-called real estate agency institutes who hold the sole right to issue the convertible bonds used to finance homes. However, with amortization free loans, maturities running up 100 years and adjustable rates it merely seems as if Denmark has had its own distinct subprime lingo rather than holding the high ground as many claim. So far though none of these major credit institutions have shown signs of distress while at the same time many analysts expect banks in the mid-size segment (e.g. Roskilde Bank, Amagerbanken, Fionia Bank, and Forstædernes Bank) to be in the frontline of the barrage which may come next. Yet, as house prices continue to drop and as delinquencies steadily rise, it is not certain that old dictums and assertions may not be in a need of some speedy revision.

Needless to say, I believe that the housing sector and the link to the financial sector and then over to the real economy is crucial to watch in a Danish context. At this point, Denmark may very well be able to navigate the skerries which lie ahead but I definitely think that the ingredients for something much more dramatic are there.

Labour Market and Demographics; an Economy at Full Capacity

Having described the housing sector above we turn now to the labour market. Even though many would perhaps, tongue in cheek, call yours truly a bit of a demographics fundamentalist I do not think that it is entirely out of place to say that if you want to understand the Danish economy at the present moment, it is all about demographics.

As can be seen from the unemployment chart above, recent years have steadily ground down Danish spare human capital. But in reality an unemployment rate running at 3.8% in 2007 does not really tell the whole story here, since if we look at the monthly development we can see that unemployment dropped to an almost unbelievable level of 1.7% in May or a mere 47.500 people. These levels adds a whole new perspective to the adage of full employment. Even as the economy contracted in the two last quarters it still created employment, albeit at a slower pace than in recent quarters.

Obviously, the number of new jobs created will steadily decrease as the slowdown grabs hold but there is a silver lining to all this. Given the demographic analysis I field below we may in fact be witnessing an economy at its historical peak in terms of capacity to produce economic growth or more aptly economic trend growth; (migration as always may adjust the path of the process). This conclusion is mainly pinned on the supposition that economic growth at all points in time is driven by people, or more specifically; the right mix between the quality and quantity of human capital.

The formal picture of Danish demographics is shown in the chart below as it plots the Danish population and its growth rate.

The series for natural increase also includes migration which is why there is a spike around 2005-2007 as Denmark received a large batch of workers from Eastern Europe; especially Poland. However, one thing is total population growth and quite another is the proportional change of the population. Thus, if one wants to understand what it means that the economy is at its "peak" one need to accept the tenets of demographic economic analysis which isn't that difficult once you get down to the basics.

Firstly, we need to take a look at two process which combines to form a steady process of ageing of the Danish society; fertility and life expectancy. Starting with the former we actually get a quite interesting picture.

The graph above is very thus very illuminating. Not only does it show that Denmark like most other societies has gone through the demographic transition with a subsequent drop in fertility, it also shows how the decline in fertility during the final (and at this point still ongoing) stages of the demographic transition is driven by two processes. One the one hand you have the tempo effect (also called birth postponement) which covers the process by which women postpone the birth of their first child. This has a knock-on effect on the second process (the so-called quantum effect) which is really synonymous with the fact that women choose to have fewer children in total. The main quibble with measuring the quantum effect is that it can only be done post-hoc through measurement of total-cohort-fertilty, although some "on the fly" proxies such as ideal family size can be used to get an impression of what is happening.

As can be seen Danish women have definitely taken birth postponement to heart, but luckily the quantum effect in Denmark seems to be much less pronounced than in some of the very low fertility European societies. Thus, Denmark is one of the few countries (France would be another example) who have been able to rebound from close-call brush with lowest-low fertility (a TFR of 1.5). On the other hand, on the life expectancy front Denmark is not particularly different in that she is, like most other OECD countries, experiencing a steady, and nearly linear, increase in life expectancy for both sexes.

The decline in fertility and increase in life expectancy taken together serve to produce a steady population ageing process which can be fairly easily tracked through either the rise in the median age of the population, or, more intuitively, via the decline, relative to total population, of the most productive cohort. In this case, I have chosen to label the cohort the proportion of the population aged 25-49.

As can be seen this age group peaked in Denmark around 1997 and is now set to steadily decline. Clearly, and given the fact that Danish fertility seems healthy in comparative terms at about 1.8 child per women, this decline will fairly be slow.

The main point to take away from all this is thus not that Denmark should now be grouped together with the strong demographic decliners like Italy, Germany and Japan, but rather that Denmark may well, in these very quarters we are passing through now, be operating at a level in terms of disposable human capital to which it will never, all things being equal, return. This does not mean that Denmark's economy won't grow but simply that momentum of growth steadily will decline from this point on. None of this is certain of course but the real silver lining is indeed to be found in the graphs above.

Consider the following. The women born at the end of 1960s as well as the beginning of 1970s are about to finish their reproductive period and an educated guess will suggest that a total cohort fertility will clock in at about 1.8 children per women. This achievement is quite extraordinary since it comes on the back of a generation of women whose fertility slumped to 1.5-1.4 in the middle of the 1980s. However, Denmark is then only now entering the interesting period since it is absolute crucial that the women who are now set to begin birth postponement (i.e. those born in the 1980s) manage to stay at a fertility level around 1.8. In fact, the postponement effect itself may well mean that Denmark will experience a marked drop in TFR in the years to come. Moreover, it is not difficult to see that if the population momentum is to be sustained, fertility needs to be considerably higher since these women come from a comparatively small generation. This same intuition can be applied to the labour market where the generation now set to enter the labour market is comparatively small. Actually, another adverse effect of the fact that a relatively small generation is about to enter the labour market is that the housing market correction may be much longer since the first-time buyers who are coming out of school in these very years are quite simply not enough to support the glut of housing at the current high prices. Talk about bad timing!

Smooth Sailing or Dire Straits?

The immediate outlook for the Danish economy seems set to become steadily worse although there are some bright spots. The key to gauge whether the Danish slowdown will turn from bad to worse is the nexus formed by the housing/residential market and banking sector. An important indication to this potential vicious circle was given last Friday when Roskilde Bank had to throw in the towel. Real economic activity is definitely slowing but it is too early at this point to decisively call the extent of the slowdown. The bright spots, and thus what seperates Denmark from some of the other casualities of the credit crunch, is that she will be going into the slowdown with a surplus both on the public and external books. In my opinion, the housing market and the extent of the incoming correction is absolutely crucial in the context of assessing what comes next in the Danish economy. If the correction is very severe the slowdown could become disorderly. So far, I will hold off my call but the smooth sailing is definitely over and a firm grip is now needed on the helm if the upcoming skerries are to be navigatied without a capsize.

Apart from the immediate outlook in Denmark I have also fielded a demographic profile and explained how one might deduce some important information about the future path of the Danish economy from this. The key is the extent to which the current slowdown will coincide with more structural factors to make things rather more worse for the Danish economy than one might otherwise expect.

Ultimately, I do not see Spain-like conditions in Denmark but all the necessary factors are definitely in place for something rather worse than what we are currently observing.

List of Main References

Danish Central Bank (2008) - Monetary Review 2nd Quarter

Bocian Steen (2008) - Danmark i teknisk recession… men påsken driller, Danske Bank Flash Comment

Bocian Steen, & Stramer Damgaard, Tore (2008) - Danmark: Ustadigt bygevejr, Danske Bank Investment Analysis

Erland, Esenspen, Lundsgaard, Jens and Huefner, Felix (2006) - The Danish Housing Market: Less Subsidy and More Flexibility, OECD Working Paper

Lunde, Jens 2005 - Fluctuations and Stability in the Danish Housing Market: Background, Causes and Policy

European Central Bank, The (2003) - Structural Factors in EU Housing Markets.

Slacalek, Jirka (2006) - What Drives Personal Consumption? The Role of Housing and Financial Wealth, German Institute for Economic Research, DIW Berlin

On the face of it the BOJ's dilemma is not so different from other central banks' in the sense that it is impossible to focus on growth and inflation at one and the same time. Yet, Japan is obviously a bit different since in this particular case there is the issue of continuing deflation in US style core prices while headline inflation is shooting up through the roof. For a visualization of the level form of price developments I can refer to my most recent assessment of the Japanese economy. What the graph below shows is the widening spread between the core-of-core price index (formally in deflation) and core price index.

It can easily be seen that this is not for the faint of heart and to make things worse wholesale inflation rose to a 27 year high in June. This suggests that a lot of inflation is creeping up through companies' supply and value chains. Now, there are arguments as to why we should not expect the link between wholesale and consumer prices to be particularly strong but it still confronts the BOJ with a set of quite un-welcome fundamentals.

In a slightly wider perspective it is quite interesting to witness the extent to which the BOJ's governing council under the charge of, the recently appointed, Masaaki Shirakawa basically has continued to tread the path laid out by Fukui. This would be the path then, on which extreme caution is exercised towards moving on rates in either direction. The interesting part of this is that Shirakawa was appointed as the main man of the BOJ, after a spectacle worthy to the annals of theatricals, in the expectation that he would hawkishly re-commence the very slow process of interest rate normalization in Japan. So far he and the rest of the council have been disappointing the hawks; that is, unless you take a whole new perspective of central bankers' propensity to gradualism.

In a more fundamental light the BOJ has simply recognized that the recovery is not on track and that the wisest road to take would be not to flog consumers (and companies) with increasing rates in the context of stagflation. More specifically, the ghost of deflation still lingers and I think it is safe to say that the BOJ is not inclined to risk increasing rates in order to combat inflation only to face the probability of re-introducing ZIRP. This would be a mirror image to the Bundesbank like attitude epitomized by the ECB and its recent preemptive move against inflation in a situation where the economic edifice is visibly crumbling. It is still too early to tell which of the global central banks that will emerge in the right. I think the BOJ is right not to push rates up but the current environment is not an easy one; that is for sure. Another thing which is making it a bit easier for the BOJ is the sudden abating of external pressures. In this way, it was only back in 2006 and beginning of 2007 that consecutive G8 meetings were ripe with comments to talk up the Yen and to push Japan to normalise rates more quickly. As a much welcome breather for the BOJ recent G8 meetings have not been concerned about the Yen but about the USD, the Fed's easing of monetary policy, and the inflationary nexus it represents as a result of USD pegging emerging markets.

One could however easily imagine the spotlight turning to Japan again at some point in the near future. In such a case and assuming that headline inflation continues to post accelerated increases it is not too difficult to see how the BOJ once again may be finding itself in a tight spot.

In the context of real economic fundamentals it is not very difficult to find ammunition for why the BOJ might want to hold off its plans to raise rates. I have an overview here as well as Edward provides additional pointers with his most recent write up on exports. The only bright spot was the impressive surge in machinery orders which provide pretty strong grounds for corporate capex in the immediate future. In a recent speech, governor Shirakawa also emphasised the risks to the economy. In particular, he made the following point in the context of terms of trade which is important to latch on to ...

"The deterioration in the terms of trade that results from rises in energy and materials prices leads to an outflow of real income, as Japan depends heavily on imported resources. This exerts downward pressure on corporate profits and reduces households' purchasing power. Although business fixed investment and private consumption remain firm, due attention should be paid to the possibility that the weakening of the economy's capacity to generate income will result in weaker domestic private demand."

Now, at this point I would be understanding if readers are a little bit confused. As such and if terms of trade deterioration is the main problem would it not make sense to raise rates to pump up the currency and thus increase the purchasing power? Perhaps ... but we should remember that this only works if demand responds appropriately. If it does not you might end up, in Japan's case, to push the domestic economy into deflation. Moreover and since Japan is highly dependent on exports to grow this is also a double edged sword since an increasing currency to mitigate terms of trade would also hurt companies' competitiveness; even if many would argue that the current value of the Yen would merit this.

On the specifics of monetary policy Shirakawa notes the reluctance of the BOJ to pre-commit;

"As I have explained, the outlook for economic activity and prices is highly uncertain at present. In this situation, the Bank considers that it is not appropriate to predetermine the direction of future monetary policy. Based on a thorough examination of the economic and price situation as well as the market situation both at home and abroad, the Bank will carefully assess the future outlook for economic activity and prices, closely considering the likelihood of its projections as well as relevant risk factors, and will implement its policies in a flexible manner."

This is basically central bank speak for "on hold" and would be very weary of calling a move either direction throughout the rest of 2008. For the chart hungry the BOJ's June report on the economic development is the place to go. It basically reiterates all the main points touched above. Japan will continue growing albeit at a slower pace which is going to be determined by the extent to which exports will continue to expand. Prices provide a risk but against the sharp backdrop of consumer spending and domestic activity this latter point is where the focus is.

The Perpetual Holding Position?

Anything short of cataclysmic events point towards the BOJ holding rates during the meeting next week. So, isn't this just the easiest job in the world being a BOJ watcher? At the moment it certainly seems to be quite an automatic exercise in terms of the direction of policy; quite simply there does not seem to be one which translates into a solidified holding operation. A couple of events however might wrestle the BOJ out of their current stance; in either direction.

• One would be a return of inflation in core-of-core prices. I have argued (see links above) why I think this is unlikely but given that fact that the US style core index is running at "only" -0.1% it is not impossible to imagine a return to inflation. In such a scenario and given the current focus from investors and international policy makers on inflation it could prompt the BOJ to raise. I think however that it would take something in the region of three month's consecutive positive and increasing reading before such a move be considered.
  

• Another event which could provide some action is a return of the focus on Japan as the main global liquidity anchor. This would be a return then to the days of 2006 and beginning of 2007 where Japan and its currency were the main talk of the town. If the economic fundamentals continue to deteriorate at the steady pace most analysts expect I have a hard time seeing the BOJ being bullied into raising rates. However, it would serve investors well to remember that what brought the BOJ to 0.5% in the first place was actually the very same pressure from G8 that I am suggesting will return. Edward Hugh's note at the time provides an excellent overview of the situation.

• Finally, we should not dismiss the possibility that things take a turn for the worse and to such an extent that the BOJ be forced to lower rates, perhaps even reintroducing ZIRP. In a world where inflation is perceived the main culprit for the incoming economic ills such a move won't be easily wringed by the BOJ. One thing which could prompt such a scenario is the the solidification of deflation in core-of-core prices. As with the mirror situation described above I think it would take a marked deterioration in domestic inflation and demand dynamics before the BOJ considers this. At this point it is very difficult to gauge where the market discourse goes in the future. One could then easily imagine that fears of growth will return to the market in which case the BOJ's ability to sneak back into ZIRP will be eased.