Goldman Sachs Basic Economic Forecast Update

Trade Update: Go Long EUR/$ to Take Advantage of the Dollar Correction June 9, 2009

7:24 AM Tue Jun 9 2009

The Dollar has appreciated recently on the back of higher risk aversion. We think this offers a good entry point to go long EUR/$. We see 5 drivers for dollar weakness in the near to medium term:

1) The recovery in global growth expectations is leading to a broader pick-up in risk appetite and a normalization in money markets as our Financial Stress Index continues to highlight. Lower money market rates and reduced dollar funding pressures reduce safe haven Dollar demand and allow Dollar depreciation.

2) Related to the previous point, we expect commodity prices to continue to rise. With the oil-Dollar correlation re-emerging we think that higher commodity prices will lead to a weaker Dollar. As we have shown in the past, the causality typically tends to run from commodity prices to FX.

3) Throughout this recovery in global growth, the US is likely to underperform in terms of domestic demand as the US consumer is adjusting its level of spending lower (and its savings rate higher). The US output gap is estimated to be among the largest of any major country.

4) Together with weaker domestic demand, the FED will likely be more aggressive with monetary easing than the ECB, thus creating conditions for a weaker USD. The rather hawkish tone of the ECB last Thursday supports this argument.

5) The continued talk about the SDR as a new synthetic reserve currency undermines confidence in the currently dominating reserve currency, the Dollar. Note that the SDR basket only contains about 40% USD (37% for the EUR) compared to the current share of about 60% (30% for the EUR) in EM central bank reserves globally. Finally, talk about BRIC countries invoicing their international trade in each other's currencies further questions the future of the Dollar as reserve currency. While be believe that changes are a long way off, these reserve related factors add to the Dollar negative sentiment.

The timing is now opportune for new EUR/$ longs. Driven by the improvement in the rate of global growth, the market has been very aggressive in terms of pricing tighter monetary policy in the US. However, we disagree with this market movement. We think the level of growth will remain below trend and US rates will be kept low for a considerable period of time. If and when expectations for tighter Fed policy get scaled down, the Dollar will likely come under renewed pressure. In addition, our GS Sentiment Index indicates that the speculative long position that had built up in EUR/$ over the last few weeks has been completely washed out.

Finally, despite the fact that the EUR/$ has appreciated sharply, the EUR TWI has been more stable due to relative EUR weakness relative to peripheral currencies, in particular the Pound. This has allowed overall financial conditions in Europe to ease over the last few months as our Eurozone FCI also indicates, mostly due to equity markets strengthening. EUR/$ strength has therefore been much less of a growth hurdle.

We would go long EUR/$ with a stop on a close below 1.3720 for an initial target of 1.45.

GS FX Research

Interesting Chart

Largest Detractors From 2008 S&P 500 Earnings Per Share

Comments From Goldman Sachs Re Fed Policy

US Daily: The Ps and Qs of Unconventional Easing (Tilton)

7:58 PM  Wed Mar 18 2009

h    The Fed offered a kitchen sink of “unconventional easing” measures today including commitments to purchase up to $1.15 trillion of Treasury and agency securities.  We view this as a positive step towards easing financial conditions and supporting the eventual stabilization and recovery of the economy.

·        Last week, we estimated that it would “cost” the Fed $1 trillion to $1.6 trillion of balance sheet expansion to generate an unconventional easing in financial conditions equivalent to a 100bp cut in the funds rate.  Today’s announcement and consequent move in the GS Financial Conditions Index implies a “bang for the buck” of about $1 trillion per 100bp-equivalent easing, although it is too early to judge the full impact of the move.

·        As we noted last week, the key caveat of our balance-sheet-to-funds rate analysis was that it focused only on “P”—the price of credit—rather than “Q”—the quantity of credit.  That emphasis is appropriate for the measures the Fed offered today.  However, the Fed is also trying to increase the flow of lending directly, via the Term Asset-Backed Securities Lending Facility (TALF) program.  Officials are so optimistic about this approach that they have hinted via media reports at a second major expansion of the concept (to include legacy assets) before the first subscription period has even been completed. 

·        To gauge the possible “bang for the buck” of the Fed’s attempt to boost the “Q” of credit via TALF, we estimate the potential impact on auto loan volumes—and ultimately on sales and GDP.   As a best-case scenario, we consider the possibility that issuance of auto-related ABS returns to the average rate over the 2006-2008 period.  If all of the incremental issuance translated into new lending, and new lending translated one-for-one into domestically manufactured vehicle sales, this would boost GDP by roughly 0.5% at a balance sheet cost of less than $100 billion.  This implies that the TALF approach could be an order of magnitude more efficient (from a balance sheet standpoint) than the approach of buying assets to lower credit spreads.  However, unlike with asset purchases, the ability to scale the TALF is constrained by banks’ willingness to lend and the ultimate end demand for borrowing.

 

The Fed offered a kitchen sink of “unconventional easing” measures today: a stronger commitment to a zero funds rate, an expansion of agency debt purchases by $100 billion and of agency mortgage backed-securities purchases by up to $750 billion, and a commitment to buy up to $300 billion of Treasury securities.   Although we thought the Federal Open Market Committee would ultimately take these actions, doing them all at once and in large size sends a clear message that the Fed recognizes the downside risks to economic activity and is determined to mitigate them as much as possible. We view this as a positive step towards easing financial conditions and supporting the eventual stabilization and recovery of the economy.

Last week, we estimated that it would “cost” the Fed $1 trillion to $1.6 trillion of balance sheet expansion to generate an unconventional easing in financial conditions equivalent to a 100bp cut in the funds rate (see “Unconventional Easing—Not Much Bang for the Buck So Far,” US Daily, March 10).  Today’s action by the FOMC gives us another data point for our analysis.  Given the size and broad market implications of the announcement, we can simply look at the total move in the GS Financial Conditions Index (GSFCI) and convert it to a funds-rate equivalent (for more on the GSFCI, see our “Understanding US Economic Statistics” publication, pp. 15-17). 

On the day, the GSFCI eased 41 basis points, equivalent to 117 basis points of Fed easing (given the 35% weight of the short-term reference rate in the GSFCI).  With a total “cost” of $1.15 trillion in asset purchases, this implies a cost of just under $1 trillion per 100 basis points of conventional Fed easing—at the low end of our previously estimated cost range of $1 trillion-$1.6 trillion, and hence at the high end in terms of “bang for the buck.”  (The true cost might be smaller, and hence effectiveness greater, if asset markets partly anticipated the move today, although our sense from media reports and conversations with clients is that most market participants did not expect a major announcement; any “consensus” for balance sheet expansion would have been in the low hundreds of billions at most.) Of course, it’s a bit early to definitively judge the impact of the Fed’s action, as the purchases under this program have not yet begun. 

As we noted at the time, the key caveat of our balance-sheet-to-funds rate analysis was that it focused only on “P”—the price of credit—rather than “Q”—the quantity of credit.  That emphasis is appropriate for the measures the Fed offered today, since they do not directly generate new lending but simply provide an incremental source of demand for debt securities. 

However, the Fed also is trying to ease balance sheet constraints and increase “Q”—the flow of lending—directly, via the Term Asset-Backed Securities Lending Facility (TALF) program.  Broadly speaking, this is an effort to restart the securitization process by providing low-cost, non-recourse funding to investors who purchase asset-backed securities (ABS) that meet the Fed’s requirements. Officials are so optimistic about this “private capital, public leverage” approach that they have hinted via media reports at a second major expansion of the concept (to include legacy assets) before the first subscription period has even been completed. 

To gauge the possible “bang for the buck” of the Fed’s attempt to boost the “Q” of credit via TALF, we estimate the potential impact on auto loan volumes—and ultimately on sales and GDP.   As a best-case scenario, we consider securitization of auto-related ABS returning to the $73bn annual rate it averaged over the 2006-2008 period, from essentially zero in recent months.  If this additional issuance translated dollar-for-dollar into new lending—an aggressive assumption, especially since issuers could begin by securitizing loans made in the last 18 months—and all of that represented incremental spending on domestically manufactured vehicles, the boost to GDP would also be $73bn, or 0.5%.  (Keeping ABS issuance at that level would continue to support the level of GDP, but would not provide any further growth.)  Of course, this incremental easing of credit conditions would not show up directly in the GSFCI, again because it measures financial conditions in price rather than quantity terms.

This example, vastly oversimplified though it is, makes two points clear.  First, unconventional easing that actually generates a higher volume of lending—i.e. the “Q” approach to credit easing that the TALF is pursuing—has the potential to have much higher “bang for the buck.”  A 0.5% boost to GDP from $73bn of balance sheet expansion (actually a bit less, since the investor has a small equity stake) would imply nearly a 7% boost to GDP from $1 trillion in balance sheet expansion—an order of magnitude higher than our FCI calculations for “P” approaches suggest.  Second, however, the extent to which the Fed can employ the “Q” approach is quite constrained: there is only so much end demand, and banks are only willing to lend so much even at a very low cost of funds.  Conversations with several market participants suggest that the actual impact of the TALF on auto ABS issuance is likely to be significantly smaller than our “best case” scenario above.  Also, auto loans are probably the area where incremental lending translates most clearly to spending, since most vehicles are bought on credit.  So while the TALF approach is potentially highly efficient, it remains to be seen how scalable it will be. 

 

Andrew Tilton

 

Goldman Sachs Note

Goldman Sachs Now Expects Q1 GDP of -7%

US Daily: Sharper Near-Term Correction Leads to 10% Unemployment by Year-end 2010 (McKelvey)
5:58 PM Mon Mar 2 2009

We have marked down our forecast for US economic activity in the first half of 2009; we now expect real GDP to fall at annual rates of 7% this quarter and 3% next quarter (versus declines of 4½% and 1% previously).
· The good news is that the bulk of this change is in business investment, which typically lags other sectors of the economy. Meanwhile, the steepest decline in consumer spending appears to be behind us. However, since this is already built into our forecast for remaining quarters, no further adjustments to our GDP outlook appear warranted at this time.
· As a result of the additional near-term weakness, we have boosted our expected path of the unemployment rate, to 9½% by year-end 2009 and 10% by year-end 2010; both figures are ½ point above the previous forecast. We have also marked down our estimates for the year-to-year change in consumer prices, to 1% by year-end 2009 (from 1.2% previously) and zero by year-end 2010 (from 0.5% previously).

As we noted in last Friday’s US Economics Analyst, the risks to our expectations for near-term US economic activity swung sharply to the downside last week as a result of four developments: (1) a larger-than-expected downward revision to last quarter’s setback, featuring markdowns to several components of domestic demand including a big one (0.8 percentage points) to the annualized decline in real consumer spending; (2) fresh signs of weakness in industrial activity, notably in orders for and shipments of nondefense capital goods; (3) further evidence of a sharp correction in housing activity; and (4) ongoing deterioration in the labor market, implying that the negative multiplier remains in full force. However, with several key reports due for release this morning, we held off making revisions until today.

Although these reports rendered a split verdict, downward revisions are still warranted to our expectations for US economic activity in the first and second quarters. Specifically, we now think real GDP will fall at a 7% annual rate this quarter and at a 3% annual rate next quarter. These figures compare to -4½% and -1% in our previous forecast. Quarterly details of this and other adjustments, also described in this note, are shown in the exhibit at the end of this comment.

As large as these changes are, they could have been worse if not for the mixed nature of this morning’s data. The saving grace was the 0.4% increase in real consumer spending reported for January. Although this could disappear on revision, it is the second gain in three months. The uptick in November, while only about half as large as first reported, remains reasonably sizable at 0.3% (3.6% at an annual rate). More significantly from a forward-looking perspective, consumers will begin to see some benefits from the recently enacted fiscal package, which should help ease the tight budget constraints imposed by the labor market deterioration. In addition, the tightening in credit standards during the second half of 2008, which probably played a significant role in the contraction in consumer spending, has since eased.

Thus, we take the better-than-expected data on consumer spending as a promising sign that the worst declines are over in this sector—we now think real spending will be roughly flat this quarter and start edging up next quarter, a bit earlier than before. In this regard, it is noteworthy that the saving rate rose to 5.0% in January from an upward-revised 3.9% level in December. Although this jump reflected two nonrecurring special adjustments to disposable income in January, both of them (a large cost-of-living increase in social security benefits and an even larger reduction in estimated personal income tax liabilities) represent genuine, if one-off, increases in after-tax income. Moreover, in coming months they will be replaced by additional boosts from the fiscal package, as already noted. For households who are determined to raise their saving rates quickly, these boosts will help them reach their goals with less parsimony than would otherwise have been required.

On the negative side of the data ledger, the latest report on construction outlays was much worse than expected, both in terms of the change reported for January (-3.3% versus our lower-than-average -2.0% call) and because of large revisions to November and December (2.3 and 1.0 percentage points, respectively). Although these data largely get ignored by market participants because they usually come out alongside the ISM report, they are quite important for pegging the trend in the construction components of real GDP. Given the depth and widespread nature of these declines across (residential, business, and government) subsectors of the construction industry, they overrode the positive implications of the better-than-expected consumer spending figures. (The ISM report, while also better than expected, implied an ongoing significant decline in US manufacturing and in any event does not figure directly into the GDP “bean count.”)

On balance, the pattern of recent data surprises and their impact on our economic outlook is encouraging in the sense that our forecast adjustments are concentrated in sectors that tend to lag economic activity. Thus, we have marked down estimates for real business fixed investment and real inventory investment, taking on board the unexpected weakness in capital goods orders and shipments as well as today’s construction data. Meanwhile, we have brought forward by one quarter the expected stabilization and subsequent slow improvement in real consumer spending (into the current and next quarters, respectively). The exception is housing, which appears to be even a larger drag in the current quarter than we had anticipated. However, given the low levels to which starts have fallen, we continue to think that homebuilding will stabilize later this year.

Unfortunately, our GDP revisions have negative implications for both unemployment and inflation. Specifically, we have boosted the profile for the unemployment rate to 9½% as of the end of 2009 and 10% as of the end of 2010. Both figures are ½ percentage point higher than before. (For the technically minded readers, our cumulative revision to GDP is about 1 percentage point as of the second quarter, which by Okun’s Law should be associated with an unemployment that is about ½ point higher). On the inflation front, we now expect the core CPI to rise only 1% over the four quarters of 2009 and to be flat, on balance, over the four quarters of 2010; these figures are ¼ and ½ percentage point lower than we previously thought.

With one critical caveat, the silver lining in these clouds is that unemployment and inflation are generally also lagging components of economic activity. (Unemployment leads at business cycle peaks but lags at cycle troughs.) The caveat is that the forecast revision underscores the likelihood that the US economy will endure a bout of at least mild deflation in consumer prices, if not in 2010 then in the period immediately beyond that. This is fundamentally different than the “technical” deflation we expect this year in the headline indexes, which is driven by a sharp and (so far) unsustained drop in energy prices. In principle, deflation can be self-reinforcing if price expectations are backward-looking. In this situation, consumers put off discretionary spending in anticipation of increases in real purchasing power and higher real interest rates—inevitable in markets where nominal rates are already zero—deter borrowing. However, if expectations are sufficiently forward-looking, then economic policies that are highly expansionary should head off such behavior, especially if the economy is showing signs of recovery.

Ed McKelvey

Exhibit 1: Key Numbers in the US Economic Outlook

Taken From Goldman Sachs Research Note

A Significant “Daily Reversion” Pattern is Now Apparent in US Equity Returns

Peter Berezin

January 26, 2009 

When the Short-term Trend is Not Your Friend 
It is often argued that equity markets are ‘trendy’. Indeed, over the past century, daily returns on the S&P have had a slight positive correlation. That is, the market has tended to do better if the previous day’s return was positive. However, this correlation in daily returns has shown a notable pro-cyclical bias. It is has tended to be positive during bull markets and negative during bear markets.

This has been particularly apparent over the past year. Since the start of 2008, the S&P has declined by 43%. Yet, if one only held the market on days following a down day, one would have earned a cumulative return of 36% (ignoring transaction costs and interest earned on days when one is out of the market). In contrast, if one only held the market on days following an up day, the cumulative return would have been -58%.

In terms of daily (close to close) returns, the average return since the start of 2008 following down days has been 0.28% while the average return following up days has been -0.62%, a daily difference of 91 bps.

Since October, this pattern has become even more pronounced. The average daily return following down days has been 0.24% compared to -1.06% following up days, a difference of 129 bps.

Interestingly, despite the stabilization in equity markets over the past two months, the anomaly has only increased. Since December 1^st, the average return following down days has been 1.15% compared to -1.24% following up days.

Other US indices such as the NASDAQ Composite have shown a similar pattern. Outside the US, however, the pattern is less discernable. It is fairly pronounced for the FTSE but does not appear to show up for either the DAX or the Nikkei.

Nevertheless, even though the pattern is less noticeable in non-US indices, it still seems to significantly affect non-US stocks traded in the US. For example, the difference in daily returns depending on whether the previous day’s return was positive or negative is even greater for the MSCI EM ETF than for the S&P. Indeed, the MSCI Japan ETF shows a large differential in returns – 91 bps – even though the Nikkei itself shows no such pattern.

What’s Going On?
How can one explain this? Part of the explanation seems to be quite straightforward. As mentioned above, the correlation in daily returns has tended to be negative in bear markets and positive in bull markets. As such, what we saw in 2008 was a return to what we saw in 2002-03. Intuitively, it appears that investors overreact to large swings in stock prices during bear markets, with the result that good days are followed by bad, and vice versa. In this respect, tracking the evolution of this correlation in daily returns is important from a market timing perspective, because it has historically helped to confirm a bottom in equity markets.

However, the magnitude of the negative correlation in daily returns that we are seeing now seems to be much greater than in past bear markets (indeed, it is even greater than during the Great Depression). This suggests other technical factors are at work. What they are is not clear, but they most likely have to do with the changing microstructure of US equity markets. This may have to do with shifts in leverage, positioning, or the behavior of index tracking ETFs – especially of the leveraged variety.