>STRATEGY FORUM (MORGAN STANLEY)

INTRODUCTION

We have generally become more constructive on the global investment outlook. This week we address the increasingly bullish outlook from our economists and strategists. With this changing stance in mind, our US economist David Greenlaw talks about the potential for upside surprises in the third quarter and other economic news. Qing Wang, our China economist, touches upon continued upgrades to his numbers. And finally, Jonathan Garner, our Asia/GEMs equity strategist, discusses his more upbeat outlook for Emerging Markets, especially China.

— Greg Peters

US ECONOMICS

Pickup in Motor-Vehicle Output Points to Potential Upside for 3Q GDP

Rethinking our haircut on motor-vehicle impact to 3Q GDP. When Dick Berner and I recently bumped up our GDP growth estimate for 3Q from 0.0% to 1.0% and cut our 4Q number by 0.5 percentage points, to +1.5%, we cited a new assumption for motor vehicle production as a source for much of the forecast change. For some time, we have been aware of automaker plans to build a lot of vehicles in 3Q. However, we were skeptical for various reasons. Thus, we applied a haircut to the impact implied by strict adherence to published assembly plans and assumed about a 2 percentage point add-on to 3Q GDP (still very large by historical standards).

We now think the impact could be even larger for three reasons: (1) Data we received last week indicated a June overbuild — the first in quite a while. This is consistent with a ramping up of output heading into 3Q. (2) Recent industry reports suggest that fleet sales may be poised to rise over the near term. And (3) data for the first few weeks of July suggest that production is running close to the original plan.

Outlook for 3Q to be revisited. At face value, the auto industry’s latest assembly schedules imply a 3Q add-on to GDP of nearly 6 percentage points — which would represent an all-time record by a very wide margin. So we believe there may be some meaningful upside risk to our +1.5% estimate for 3Q GDP. Could GDP be +3% or even +4% in the current quarter? Possibly, but because of the potential noise in the data, we're not changing our official forecast. We will revisit the issue in another week or two when more information is available.

Would a strong 3Q borrow from 4Q? The answer depends on the automotive sales picture in the next few months. We believe that inventory levels across the industry are close to normal at this point. And near-term production plans appear to be consistent with about an 11 million unit annualized sales pace. If sales are close to that rate, then motor vehicle output can probably be sustained at the 3Q pace for a while longer. Thus, we could see a neutral contribution for auto output in 4Q. However, if sales disappoint over the next few months, then production is likely to be scaled back later this year.

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