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Economic Review 4th Quarter 2010 No. 23 A large surplus in the current account of the balance of payments The surplus in the current account of Israel’s balance of payments amounted to US$4bn in the first half of 2010, similar to the level from the second half of 2009. In this period the deficit in the foreign goods account increased, primarily as a result of a rise in expenditures on the import of fuel and diamonds, while the surplus in the services account widened, primarily as a result of the rise in the export of transportation services (cargo transport between foreign ports by Israeli shippers abroad). When analyzing the trend in recent years of the current account in terms of GDP, which is the recognized method for comparing the balance of payments of countries, in Israel there is an increase in the surplus, as can be seen in the accompanying graph. This surplus, which is expected to amount to 3.8% of GDP in 2010, is one of the factors supporting the strength of the shekel and its basic tendency towards appreciation. In addition, there is a surplus of Israeli-held assets over liabilities in overseas debt instruments, in the amount of US$50bn. If we broaden the scope to include not only overseas debt obligations, but also the stock component, then the amount of overseas assets and liabilities of the Israeli economy indicated also at the end of the second quarter a surplus of assets held by Israelis over overseas debts, in the amount of US$1.2bn. These data, which show that Israel continues to be a lender to the world, and not a borrower as was the case for many years, also reduce the risks that can come about from a weakening of the shekel, and thus support as well a strengthening in the local currency. A decline in the export and import of goods in August In August there was a decline in both exports and imports of goods, compared to July (excluding seasonality). The decline was registered in all central components of imports, as well as in industrial exports, which is the central component of the export of goods. Is this widespread change significant? In our opinion it is important to wait and to be cautious about jumping to conclusions, especially in light of past experiences in which there were cases when there were substantial revisions of previous monthly data. However, when analyzing the long-term trend of surplus/deficit developments in the foreign trade “basic” goods account (which is the goods account excluding ships, aircraft, fuel and diamonds) it appears Israel is still in surplus, after many years of a deficit, see graph. The improving trend in this “basic” account contributes to the surplus in the current account of the balance of payments, upon which we commented at the beginning of this review. By: Eyal Raz, Economics Sector, Leumi Israel The diversion within the Eurozone seems to gain in amplitude: Germany is steaming ahead, growing by 2.2% in 2Q, whereas fiscally challenged countries barely expand or even stay in recession, such as trouble spot Greece. This striking dichotomy is explained by the difference in economic activities among these countries, their competitiveness on the world market and, of course, the fiscal crisis that plagued Southern European countries the most. As the Eurozone remained highly dependent on the re-stocking cycle, which occurred later than in other economic zones and benefited partially also from the weak EUR, there is a high probability of a significant slowdown in the euro area in 2H of this year, even more so as export champion Germany additionally benefited from a weather-induced bounce in construction in 2Q. Leading indicators are already signaling a slowdown in the euro area, not only in manufacturing, but also in services. The level of the composite PMI is consistent with sharp decelerating expansion in 3Q. Industrial orders point to softer activity as well, reacting to lower global economic activity in recent months, which undermines exports. Encouragingly, household final consumption expenditures increased by 0.5 % in 2Q, a rare occurrence in many years. For Germany continuing to represent the engine of Europe, the success of replacing overseas with, so far muted, domestic consumption is crucial. The relatively elevated level of Germany’s IFO (a widely watched sentiment indicator, measuring business sentiment in Germany) business climate index points to friendlier investment activity. On the private consumption side, an improved labor market, also as a result of less short-term work, and seemingly future wage increases may indeed lead to somewhat more solid spending. The constantly criticized German consumer behavior finally has the potential to contribute more to Eurozone growth. Household expenditures in the rest of Europe look much less promising. Unemployment in many countries will remain stubbornly elevated or even rise further. Painful structural reforms, the removal of stimulus and impending fiscal squeeze overshadow the economy. Very importantly, the pace of fiscal adjustments differs in timing and magnitude and the impact will only be visible with a lag. We expect very sluggish economic growth for at least the next two years. Spain’s prime minister optimistically claims that the European debt crisis is over. We disagree. Record CDS spreads underline that risks for Ireland, Portugal and Greece are acute. As long as Europe lacks the courage to fundamentally change its fiscal policy mechanism, the EMU will be questioned and system-threatening events can reoccur. Additionally, the European banking stress test showed serious lack of depth, impacting the credibility of European authorities. It is an open secret that a significant number of Eurozone banks still need support from the ECB and appear unable to find alternative sources of funds. The ECB will continue to match in full banks’ demands for weekly and monthly liquidity at the prevailing main policy interest rate. We expect the ECB interest rates to remain firmly on hold - also in 2011. By: Esther Meier, Leumi Asset Management, Leumi Switzerland No "Great Expectations" Many literary scholars consider the above captioned Charles Dickens novel a masterpiece that epitomizes the story of upward mobility; the rise from poverty to wealth. Unfortunately this is not the story currently being written about the U.S. economy in the policy statements released at the conclusion of each Federal Reserve FOMC meeting. The progression of recent statements reveals a Fed with "minimum expectations" regarding the near to medium term outlook for the economy, job growth, housing, incomes and inflation. Earlier in the year, Fed statements portrayed a cautious yet upbeat tone following strong 4th Qtr. '09 and 1st Qtr.'10 economic growth. This changed in June following the Greek crises in particular, the PIIGS in general and a broad retrenchment in the U.S. economy. The June 23 statement was a downgrade in the outlook due to "...high unemployment, modest income growth, lower housing wealth, and tight credit." It also said "... financial conditions have become less supportive" and "...underlying inflation has trended lower." In the next several days; ten-year treasury rates dropped 25 bps to 2.90%; the EUR rose against the USD from 1.23 to above 1.25; and the S&P 500 fell 7.5% to 1010. At the August 10 meeting they said "...the pace of economic recovery is likely to be more modest in the near term than had been anticipated." But the most significant part of the statement was designed to calm the markets apprehension over a potential shrinking of the Fed's $2.35 trillion balance sheet (compared with about $900 million pre-crises). To avoid such a contraction the Fed, for the first time, said they will keep constant their holdings of securities at the current level by reinvesting agency debt and agency mortgage-backed security The information in this newsletter is based on sources, including published sources ,which Bank Leumi le-Israel B.M and its subsidiaries believe to be reliable but which the Bank has not independently verified. The Bank makes no guarantee, representation or warranty as to the information’s accuracy or completeness.The opinions expressed in this newsletter are subject to change with no notice. The information in this newsletter should not be construed to buy or sell, or the solicitation of an offer to buy or sell any securities or currencies. The Bank and its affiliates may have positions in the securities or currencies referred to in the newsletter, or in other securities or currencies whose value may be affected by the value of securities or currencies, referred to in the newsletter. Nondeposit investment products are not insured by the FDIC; are not deposits or other obligations of, or guaranteed by, the Bank or its affiliates; and are subject to investment risks, including possible loss of the principal amount invested. maturities back into longer-term Treasuries. By identifying balance sheet size as a policy factor, participants gained an added degree of transparency into Fed operations and thinking. Had the Fed allowed the balance sheet to contract, it would signal the gradual withdrawal of the quantitative easing undertaken during the depths of the financial crises. By the time of the August meeting 10-year government yields had fallen to 2.75% and subsequently fell to 2.45%. The USD had weakened substantially against the EUR to 1.32 by the meeting date but subsequently strengthened through month end with the EUR falling to 1.26 on concern over Euro area growth prospects. The S&P, meanwhile, had rallied 12% from the early July lows all the way back to 1130 by August 10 but then fell 7.0% to 1050 on the Feds poor economic outlook and the stronger USD. At the recent September 21 FOMC meeting, the Fed communicated for the first time an unease over what they believe to be a growing deflation risk. They said "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. They added that "... inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate." Ten-year rates now remain pegged at 2.50%, the EUR has rallied 9.0% to 1.375 and the S&P has maintained an 1120-1150 range. Gold has reached an all time record high of $1320. To this writer, who has observed the Fed for almost thirty-five years, the September 21 statement is an almost unimaginable development. As you may recall, the late seventies/early eighties saw inflation balloon following the "guns and butter" policies of the Vietnam War and "Great Society" programs. In addition, skyrocketing energy prices following the early 70's Arab oil embargos fanned inflation ever higher. To combat this, President Carter appointed Paul Volker as Fed Chairman in 1979 Volker vowed to crush inflation. He instituted a policy that targeted the money supply instead of the level of the Fed Funds rate and in doing so caused rates to rise to 20% in 1981. This brought the economy to its knees and caused the only (post WWII) "double-dip" recessions of 1980-1982 during President Reagan's first term. From that time onward, inflation and interest rates have been on a 30-year down trend (the "Great Moderation") to where policy rates are virtually zero and inflation is uncomfortably low. What a turnaround, or as they say "be careful what you wish for" or "beware of success". The Fed has indeed successfully fought inflation for 30 years and now, given the collapse in aggregate demand and financial de-leveraging: is it so implausible to expect deflation? Sub-par economic growth, too low inflation and a reading of Fed statements has, in the view of many analysts, positioned the Fed to announce, possibly at the November 3 meeting, the implementation of QE2. That's not a ship we're talking about but rather a second round of quantitative easing. Leumi International Private Banking Centers Some, including several Fed officials, believe additional large scale asset purchases (LSAP) will do little to further stimulate aggregate demand or bring down the unemployment rate. Others argue that it will require several $trillions to boost GDP by 0.5% over a two year period. But others disagree including William Dudley, President of the New York Fed, who recently said "further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long." Mr. Dudley added that the purchase of $500 billion of bonds would have a significant impact. Herzelia And let's not forget the Fed Chairman himself, sometimes referred to as "Helicopter Ben", because of a speech he delivered in 2002 to the National Economists Club (the Bernanke Doctrine). In that speech he said that to combat deflation a Central Bank could simply print money; and Milton Friedman likened this to dropping money from a helicopter. Tel: +44-20-7907-8000 I strongly suggest you read that speech as you will then understand why Bernanke is unlikely to stand idly by and allow the U.S. to deflate. He will do something to preclude such an outcome. The rise in gold could be hinting that inflation is the inevitable long term outcome of additional LSAP. The cheapening of the U.S. dollar is a weapon against deflation. Lower 10-year rates near 2.25% are likely by year-end if LSAP are announced as well as will a rising equity market if the Fed goes "all-in". By: Bob Giordano, Treasury Management, Leumi USA Tel Aviv Tel: +972-3-621-7444 Tel: +972-3-621-7333 Jerusalem Tel: +972-2-620-1811 Leumi Domestic Private Banking Centers Tel Aviv Tel: +972-3-623-7300 Haifa Tel: +972-4-835-0333 Tel: +972-9-960-9311 Jerusalem Tel: +972-2-620-1877 U.S.A. Bank Leumi USA New York Head Office Tel: +1-917-542-2343 Switzerland Bank Leumi (Switzerland) Tel: +41-58-207-9111 Luxembourg Bank Leumi (Luxembourg) S.A. Tel: +352-346390 United Kingdom Bank Leumi (UK) plc Bank Leumi (Jersey) Limited Tel: +44-1534-702-525 Leumi Overseas Trust Corpration Ltd. Tel: +44-1534-702-525 Romania Bank Leumi Romania S.A. Tel: +40-21-206-7075 For more information visit: www.bankleumi.com Editing: Smadar Ilan, Head of Products Marketing Department, Leumi Int’l and Private Banking Division Tel: +972-3-514-9989 E-mail: [email protected]