House of Paine

morgan stanley sez

Big improvement in 2005 deficit.  The federal government’s budget deficit narrowed to $319 billion (2.6% of GDP) in FY2005 (September) from $413 billion (3.6% of GDP) in FY2004.  Relative to our forecast of a $335 billion deficit in the last edition of the Government Funding Watch in mid-August, the main surprise was an astounding surge in corporate tax receipts in September.  This may have partly reflected significant repatriation of overseas earnings under temporarily lower tax rates enacted in the Homeland Investment Act — a subject much discussed in the past year in the FX markets in particular but, at least through Q2, almost entirely absent from the capital account figures.

Overall revenues surged 14.6% in FY2005 — the largest gain since FY1981.  Individual income taxes also rose 14.6%, with the bulk of the upside attributable to a near record 31.9% spike in nonwithheld taxes, the bulk of which was seen during the surprising surge in receipts collected during the April/May tax season.  This apparently reflected a combination of stronger capital gains and dividends on stocks, bonds, and mutual funds, rising capital gains realizations on home sales, and underwithholding on rising bonuses and stock option exercises.  Meanwhile, combined withheld income and social insurance taxes rose 6.4%, in line with stronger job and wage growth.

Along with the surge in individual nonwithheld taxes, the main surprise on the revenue side was another huge gain in corporate tax receipts, which surged 47.0% in FY2005 on top of a 43.3% rise in 2004.  This partly reflected tax changes.  With the expiration of bonus upfront depreciation allowances at the end of 2004, we estimate that on a NIPA basis corporate book profits rose 26.5% in FY2005, well ahead of our estimate of a 7.5% gain in “economic” profits (which exclude the tax related depreciation swings).  Repatriation of overseas profits under temporarily low rates enacted by the Homeland Investment Act probably also played a role.  We cannot come up with any other obvious reason for the amazing 67% Y/Y spike in net corporate tax receipts in September (which came against a tough comparison of a 39% surge in September 2004).  There has been much made of the hundreds of billions of dollars in planned repatriations identified in corporate SEC filings over the past year, but at least through Q2 little sign of it actually happening has been seen in the international capital flows data.  But judging from the September 15 quarterly tax payment, it may have finally started to show up in a big way in Q3, and, if so, will probably carry over into December’s quarterly corporate tax payment.

This extremely robust revenue picture offset still elevated growth in spending.  For all of FY2005 spending rose 7.9%, the largest gain in three years.  After a 50% surge from FY2001 to FY2004, growth in defense spending has started to slow, but was still significant in FY2005, rising 8.1% and contributing a fifth of the overall spending rise.  Gains in the big retiree entitlement programs that have increasingly come to dominate non-defense spending (making up nearly half of total spending excluding defense and interest in FY2005) — Social Security (+5.6%) and Medicare (+10.9%) — accounted for another third of the spending upside.  With rates on the rise, net interest expense rose 14.3% and accounted for another eighth of the overall spending gain.  These four categories taken together thus accounted for about two-thirds of the 7.9% gain in overall spending.  Despite the near freeze on non-defense discretionary budget authority passed by Congress in the FY2005 budget, the carryover of unspent budget authority from free-spending prior years and some upside in other entitlement programs (the expanded child tax credit in particular contributed significantly to elevated refund growth in the 2005 tax season), other spending gained 7.0%.

But a significantly bigger deficit is expected in 2006.  Prior to the devastation of Hurricane Katrina and associated spike in energy prices, we had expected the deficit to be roughly stable in FY06 at $325 billion.  Both defense and non-defense discretionary spending growth seemed likely to slow sharply after two years of tight caps passed by Congress on non-defense discretionary budget authority and the huge build-up in defense spending to fund operations in Iraq and Afghanistan had run it course, leaving spending at a high level of about 70% above FY2000, but with little additional growth.  But offsetting this restraint on discretionary spending, already rapidly growing mandatory spending looked likely to be boosted significantly further by the phasing in of the extremely expensive Medicare drug benefit — estimated to cost about $25 billion in FY2006, interest expense was likely to post another sharp rise, and revenue growth seemed likely to revert to near nominal GDP growth after the surge in 2005.

All these diverging influences still appear on track.  The huge new swing factor, however, is the massive rebuilding cost for the devastation from Hurricane Katrina and the hit to revenues from the slower near-term growth caused by the associated spike in energy prices.  So far Congress has passed roughly $70 billion in emergency appropriations for hurricane relief and rebuilding (mostly spending, but with some tax relief for hurricane victims as well).  And significantly more appears likely.  While House and Senate leaders have been trying to gather support for offsetting cuts in other spending, these proposed plans would entail cuts to programs spread over many years, and actually passing significant fiscal restraint may prove difficult as we head into the mid-term elections.  All in all — and cognizant of the significant uncertainty surrounding the ultimate total amount of appropriations, the time frame over which appropriations are translated into actual outlays (very slowly so far it seems), and the possibility of offsetting cuts elsewhere — we are assuming an additional $85 billion in spending in FY2006 related to Katrina relief and rebuilding.

In addition, the spike in energy prices appears to have led to a significant slowing in near-term growth.  Though with gasoline prices in freefall since early October and rebuilding spending likely to provide a boost to activity, we expect the hit to be temporary, with the recent auto-led retrenchment in consumer spending, we now forecast Q4 GDP growth (the first quarter of fiscal 2006) of only 2.6%.  For full-year FY2006, we now forecast real GDP growth of 3.4%, down from our estimate of +4.0% in August.  As a result, we have correspondingly trimmed our revenue growth forecast in FY2006 to +5.4% from the +6.0% we estimated in August.  Combining the higher spending and lower revenue growth we now see post-Katrina, we expect the budget deficit to widen to $410 billion (3.1% of GDP) in FY2006 from the $319 billion (2.6%) recorded in 2005.

Treasury financing — it’s not just the reported budget.  Even if the deficit had remained relatively stable in FY2006, Treasury financing needs appeared likely to rise significantly.  With the deficit now expected to rise a good deal, we foresee sharply higher market borrowing in FY2006, which we project will require both significant net bill issuance after the paydown in 2005 and across the board increases in nominal coupon sizes, in addition to the new money raised from the revival of the long bond starting in February.

Even with the deficit coming in at $319 billion in FY2005, the Treasury only had to borrow $216 billion from the market thanks to the record flood of nonmarketable sources of financing.  Indeed, this wave of non-market financing was so large that the Treasury borrowed only slightly more in the market in FY2005 than FY2002 even though the budget deficit was more than twice as big.

Total non-market sources of financing (not including changes in cash balances) soared to $102 billion in FY2005, a record by a huge margin.  This surge in nonmarketable funding had a number of sources, including sizable repayments of various government-backed loans, very little in the way of net new federal student loans, and a big chunk of money repaid by the IMF.  However, the most significant contributor was huge issuance of state and local government series (SLGS) debt, which came to a record $67 billion for the year.  SLGS are nonmarketable Treasury securities issued directly to municipal governments to provide them with a simple way to invest the proceeds of municipal debt sales without running foul of or having to deal with the accounting hassles related to laws prohibiting them from earning an arbitrage profit on the tax-free status of their debt.  Typically, SLGS are used by state and local governments engaging in pre-refunding of outstanding debt when rates fall — a municipal government can issue new lower rate debt in an amount matching a higher rate outstanding issue and set up an escrow type account by investing the proceeds in SLGS with maturities matching the interest and coupon payments of the outstanding issues.  The low level of rates for most of FY05 and fears that it would not last apparently led to a huge surge in this type of pre-refunding activity.

This record-breaking wave of SLGS issuance cannot continue forever, however, especially as rates continue to back up, making additional pre-refundings less attractive.  Indeed, the slowdown may already be taking place as total nonmarket debt issuance in October (mostly SLGS, but also savings bonds and some other small categories) fell to an eight-month low.  And after new issuance eventually dries up, the heavy issuance done over the past year will eventually start to roll off in the years ahead as the debt that was pre-refunded with SLGS escrow accounts comes due.  There still would appear to be opportunity for continued profitable pre-refundings at current rate levels, and SLGS maturities appear to be light in the year ahead, so we are still predicting fairly healthy net issuance this year, but a good bit below the record amount seen in FY2005.  As a result, we are assuming that net nonmarketable debt issuance and other means of financing will swing from the huge $102 billion positive seen in FY2005 to +$40 billion in FY2006 and then turn negative in the next several years beyond that.

Financing needs set to rise significantly.  Combining the $91 billion wider deficit and $62 billion less in non-market financing sources we project, we estimate that the Treasury’s marketable borrowing needs will rise by $153 billion in FY2006.  As the budget deficit surprised on the upside significantly over the course of FY2005 and the non-market flood continued, the Treasury instituted across the board cuts in coupon sizes and paid down bills.  At the start of FY2005, the 2-year size was $24 billion, the 3-year $22 billion, the 5-year $15 billion, and the 10-year $14 billion for the new issue and $9 billion for the reopening.  By the end of the fiscal year, the 2-year was down to $20 billion, the 3-year $18 billion, the 5-year $13 billion, the 10-year $13 billion new/$8 billion reopening, and nearly $50 billion in bills had been paid down (at times resulting in severe disruptions to this part of the market).

We believe all of these cuts will prove transitory and will be more than reversed during 2006, with across the board increases in coupon sizes — along with an assumed $25 billion in resumed annual 30-year bond issuance — and a swing towards sizable positive net bill issuance.  Indeed, at current coupon sizes and our estimates for the budget deficit and non-marketable financing sources, we estimate that the Treasury faces a financing gap of $177 billion in FY06 (and that includes the assumption of $25 billion in bond issuance) that must be filled through some combination of higher coupon sizes and bill issuance (Note: The financing gap is the additional money that must be raised in the market through a combination of larger coupon sizes or more frequent or additional issues and net bill issuance to fund the Treasury's projected borrowing need.)  The projected financing gap remains sizeable as the maturing coupon schedule picks up significantly in coming years, reflecting the lapping of the reintroduction of quarterly 3-year note and the shift to monthly 5-year notes.

As a result, we expect to see significant across-the-board increases in coupon sizes and a swing back towards positive bill issuance over the course of FY2006.  But at this point, the Treasury seems to have significantly more positive cash flow estimates than we do, so the increase will likely not be immediate.  We were surprised at the low Q4 and Q1 borrowing projections the debt managers announced ahead of the November refunding.  The Treasury said that it expects to borrow $96 billion in 4Q and $171 billion in 1Q, which would only be $26 billion more than the comparable period last year.  At least for Q4, the Treasury’s optimism is based on an assumption that the non-marketable flood continues and actually accelerates, as it is projecting $27 billion in total non-marketable debt issuance ($7 billion) and other means of financing ($20 billion), a stepped up run rate from the record $102 billion seen in FY2005.  We’re not sure what accounts for the high other means assumption; there may be some special factor we are unaware of.  The Treasury only provides details of its financing projections one quarter ahead, so we do not know the source of the Q1 optimism.  We have made some adjustments to our estimates, but still project significantly more net borrowing than the Treasury over the Q1/Q4 timeframe — $104 billion in Q4 and $205 billion in Q1 or $309 billion total, $42 billion more than the Treasury’s latest estimates and $68 billion more Y/Y.

Given the Treasury’s much more optimistic cash flow projections, we look for the ramp-up we expect in coupon sizes to be delayed until the February refunding.  But by end FY06, we expect the 2-year size to have risen to $25 billion from $20 billion, the 3-year to $23 billion from $18 billion, the 5-year to $16 billion from $13 billion, the 10-year to $15 billion new and $10 billion reopening from $13/$8, and that TIPS sizes will hold at recent levels ($9 billion new/$8 billion reopening for the 10-year, $11 billion new/$8 billion reopening for the 20-year, and $12 billion new/$9 billion reopening for the 5-year).  We also look for $25 billion in bond issuance — likely a $15 billion new issue in February followed by a $10 billion reopening in August.  These adjustments, along with about $106 billion in net bill issuance, would close the financing gap that we project for FY2006 — about 40% of the $177 billion financing gap we estimate being made up by larger note sizes and the return of the bond and 60% in bills.  The financing picture does not get much easier beyond that if the budget stays above a $300 billion level.  Modest additional coupon size increases (on top of the increases we are estimating by the end of FY2006) and net bill issuance in the roughly $70 billion range could likely handle the projected additional financing needs we project in our base case for FY2007 and FY2008.  The sharp jump in coupon maturities in FY2009, however, when the monthly 5’s begin maturing, looms as the next longer-term potential problem point that could require more significant adjustments.



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Singapore: Property Prices to Lend Strength to Retail Sales 

Deyi Tan (Singapore) and Daniel Lian (Singapore)




September Retail Sales: Retail sales rose by 8.9% YoY in September (vs. 6.8% YoY in August).  This brings 3Q retail sales up 8.6% YoY (vs. 9.6% in 2Q). Excluding motor vehicles, retail sales grew at a marginally slower 7.4%.  Meanwhile, sales value stood at S$2,336mn compared to S$2,222mn in August.

Motor vehicle sales remained strong: The strong September number is underpinned by increased momentum in retail sales across all segments except for food and beverages (12.2% YoY vs. 15.5% YoY in August), recreational goods (-0.5% YoY vs. 5% YoY), watches and jewellery (0.8% YoY vs. 12.2% YoY) and others (-4.7% YoY vs. -0.4% YoY). Motor vehicle sales, which has been the mainstay of retail performance rose 10.5% (2.8ppt).  Departmental sales and apparel & footwear were also strong (1.3ppt and 1ppt).

Wealth and Income effect to bolster retail sales: Retail sales are set to benefit from two factors: 1) falling unemployment (income effect); and 2) rising property prices (wealth effect).  Unemployment steadied in 1Q-3Q and should edge lower as economic growth firms.  The improvement in productivity we saw in 2Q could further set real wages on an uptrend if sustained.  Employment is dependent on the export cycle and this injects a fair degree of cyclicality to consumer demand. However, a structural rise in property prices would likely cushion consumer strength from cyclical risks ahead.  Consumer spending is typically more correlated with wealth rather than income.  Housing prices and rental yields have turned from deflation and seen four consecutive quarters of growth.  The new property measures announced in July should enhance this further.  The property upturn should not only create additional demand in the furniture and household segment, which carries a significant weight (10.5%) in the retail index, but also increase overall wealth to affect the broader retail sector.



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Euroland: The Risk of Restrictive Budget Policies 

Vincenzo Guzzo (London)




Note: This is an excerpt from Government Funding Watch: The Fiscal Divide Widens by Vincenzo Guzzo, David Miles, Takehiro Sato, and Ted Wieseman.  Please see the full document for various tables and charts excluded below

Borrowing needs not as heavy as we expected.  Euro-area government funding will likely rise in 2006, but borrowing needs should be lower than we previously expected and net issuance should be broadly in line with the amounts seen this year.  We now see total gross issuance of government bonds for the four largest markets in the Euro area — Italy, Germany, France and Spain — rising to €508 billion in 2006 from an estimated €488 billion this year.  Yet this is substantially lower than the €553 billion we foresaw in our previous quarterly assessment (see V. Guzzo, D. Miles, T. Sato, and T. Wieseman, Government Funding Watch, Back on the Rise, August 12, 2005).

Better-than-expected macro outlook weighs on funding.  At least four factors lie behind this downward revision.  A better-than-expected macro outlook for the second half of this year, a tighter fiscal stance into 2006 despite the withdrawal of the Stability and Growth Pact and looming political elections in several countries, a lighter redemption profile and finally, a larger share of non-market instruments all contributed to lower the estimated supply of government bonds.  To a different extent, each of these elements helped keep funding in check at a difficult juncture.  In particular, stronger momentum in the Euro-area economy, together with heavier reliance on non-market instruments, pushed 2005 gross issuance down by around €22 billion and lowered its ramp into 2006.

Buy-backs and non-market instruments also play a role.  Other factors will weigh favourably on 2006, in our view.  France and Italy have bought back several issues up for maturity in the year ahead in an attempt to smooth some of the peaks in the redemption profiles.  We expect all issuers — in particular, Germany and Italy — to keep relying on foreign-denominated issues, non-market instruments and other means to keep net issuance in check even in the presence of a relatively heavy borrowing requirement.

Political developments did not lead to the feared relapse.  Even more importantly, the end of the Stability and Growth Pact and the proximity of general elections in the largest countries did not lead to the feared relapse in the budgets that, if anything, err on the side of fiscal rigour.  France stuck to the zero-growth rule for real spending, while leaving tax cuts on the agenda only for 2007.  Italy held a firm stance on a number of deficit-reduction measures and resisted pressure to include one-off measures, in particular tax amnesties, in the attempt to fund higher spending or lower taxes.  Finally, in Germany, fiscal policy will likely turn more restrictive in 2007, when the new government will try to bring the general government deficit back within the 3% threshold.

The transatlantic fiscal divide widens.  The lack of a discretionary fiscal stimulus has set the euro area apart from the US and the UK, where budget policies have played a reflationary role over the past few years (see Eric Chaney, No Help from Fiscal Policies, October 7, 2005).  The cumulative increase in the aggregate EMU12 budget deficit between 2002 and 2005 adds up to 1.2% of GDP, on our calculations.  This is due entirely to below-trend growth and automatic stabilisers amounting to around 1.6% of GDP over the same period, while the underlying policy stance has actually been slightly restrictive (-0.4%).  In fact, a number of one-off measures helped lower the deficit and policy was probably only neutral.  Yet, as countries try to put their debts and deficits back on a declining trend, the risk of restrictive budget policies is probably on the rise.

Back to our stylised framework.  The stylised framework we adopted earlier (for a full analysis see Vincenzo Guzzo, How Sustainable Are Public Debts?, June 27, 2005) helps analyse how, in a monetary union, weak growth might force underperforming economies towards restrictive policies.  To stabilise the debt, the primary balance must equal the interest rate gap, that is, the difference between the cost of the debt and the growth rate of GDP, multiplied by the initial debt to GDP ratio.  With the cost of the debt being broadly similar for all issuers in Euroland, what really makes a difference is the growth rate of the economy.

Monetary union force laggards to run tighter policies.  To stabilise their debts, the laggards (Italy and Germany, among others) will have to run higher primary surpluses.  More consolidation measures in the absence of growth enhancing policies, however, might well have a tightening effect on the economy, ultimately leading to even weaker growth.  The path is even more treacherous for high-debt countries, for which debt-servicing costs already absorb sizeable resources.  Our downward funding revisions for weak-growth economies precisely confirm that these countries might be moving towards tighter policies.

Revision spread across countries.  Our downward revision in 2006 gross issuance is broadly split across the three largest countries, suggesting that better macro outlook, fiscal rigour and the other technical factors we described have a widespread effect.  The breakdown along the maturity spectrum highlights lighter funding for the front end of the curve and the inflation-linked segment, while supply should remain robust relative to our previous estimates for long-dated nominal yields.  The return of several issuers to the 30-year sector during the second half of 2005 endorses this point.