Weekly Focus

Headwinds Keep Building

The past is week brought morefurther news onf how the "credit crunch" between banks among banks is spreading to the real economy. The ECB's lending survey showed further tightening of credit standards across the board:. Eenterprises, consumers and home buyers are all facing t tighter credit availability. Meanwhile, demand for credit is weakening acrossfor all sectors, and hence paintings a picture of weaker investment activity and consumer demand. The data also point to the housing downturn continuing in Euroland. Credit standards are likely to have been tightened most in the most vulnerable countries, such as Spain and Ireland, but there are no country details in the report. Further tightening in Euroland is no big surprise, as it mirrors similar developments in the US and UK. Nonetheless, it contributes to a picture of tightening credit availability at a global level.

The numbers explain why the ECB struck a more cautious note in yesterday's press statement with regard to credit (see Flash Comment - ECB keeps neutral stance). Interestingly, credit tightening is being driven mostly by a more negative outlook for economic activity, although the effect of rising cost of capital is also increasing in the survey. The survey highlights the downside risks to growth, and underpins our expectations of weaker investment spending in coming quarters. This will contribute to further slowing in the second half of the year.

Rising oil prices are another headwind to growth, and they are having a considerable impact on private consumption. The latest Euroland retail sales came in very weak, and this weakness is likely to continue as credit is tightened and the labour market starts to soften. Pressure on the ECB to cut rates will mount, but the great unknown is inflation. If oil prices rise further, inflation could rise to 4% by the autumn, which would make it very hard for ECB to deliver the cuts we currently include in our forecast.

Euroland: Oil prices the joker in the pack for inflation

It has been an eventful week in Euroland, with a rate-setting meeting at the ECB and news that the current strong headwinds are increasingly affecting the economy.

As expected, the ECB decided to leave its leading rates unchanged, and also the tone of Jean-Claude Trichet's presentation was largely unchanged from the previous meeting in April. The decision was reached on the basis of the risks to price stability on the one hand and further clear signs of moderate economic growth in Europe on the other. At the same time, the ECB is seeing the first signs of the financial crisis leading to tightening of banks' credit standards.

Retail sales in Euroland are currently undergoing their worst period since the recession of 1992-93. This was confirmed by the March figures, which showed a drop of 0.4% m/m and 1.1% y/y. German manufacturing orders also fell for the fourth straight month, dropping 0.6% m/m in March. On the other hand, German industrial production made a good start to 2008, climbing 1.1% q/q in Q1. However, we expect growth to slow in the coming quarters as the strong headwinds (a still strong EUR, slower global growth, higher oil and food prices, and credit tightening) make their mark on the economy.

It is in the first instance the rise in oil and food prices, and in the second the risk of higher wage growth, that pose a threat to price stability. Inflation in Euroland was 3.6% in March and 3.3% in April, and we expect it to move up another notch during the summer. Given the latest increases in oil prices, though, there is a risk of inflation climbing even further. However, there is a great deal of uncertainty about oil prices. We have produced two scenarios which illustrate just how sensitive inflation is to oil prices, and so highlight one of the key elements of uncertainty in the ECB's balancing act. If oil prices continue to climb, inflation will rise above 4% in the coming months, peaking in late summer and early autumn at 4.5%. If, on the other hand, oil prices fall rapidly from their current high levels, we will see a very sharp decrease in inflation through to summer 2009.

Key events of the week ahead

• Euroland GDP for Q1. We expect an increase of 0.5% q/q, in line with consensus.
• Final April HICP for Germany. Like consensus, we expect an increase of 2.6% y/y and -0.3 m/m.
• Euroland core inflation. We expect an increase of 1.9% y/y, which is a tad lower than consensus.

Switzerland: Falling KOF and rising unemployment

The past week has brought a raft of fresh data from the Swiss economy, and far from all of it positive.

The slide in the KOF leading indicator continued to accelerate, with a drop from 1.54 (1.40 rev.) to 1.20. The KOF indicator is normally a good guide to movements in GDP, and it has now been trending downwards since August last year. As in previous quarters, confidence is particularly low in the financial sector. Confidence in the economy as a whole, excluding the financial and construction sectors, has also begun to falter, although it is still sending positive signals.

The labour market report for April revealed an increase in unemployment to 2.6% from 2.5% in March. This is the first time that unemployment has risen since April 2005, and there is no reason to believe that this is a one-off. UBS, the country's biggest bank, has just announced plans to cut its workforce due to losses from the sub-prime crisis, and higher oil prices will put pressure on corporate earnings going forward. Both factors will in all probability make their mark on future unemployment statistics. That said, the Swiss labour market is still strong.

Turning to the good news, consumer price inflation fell from 2.6% y/y in March to 2.3% y/y in April. As in the previous month, it was mainly oil products that pushed up consumer prices; core inflation was just1.3% y/y. Thus inflation is heading towards the Swiss National Bank's target of 2% y/y, as predicted in the bank's latest inflation forecast in March. Thomas Jordan from the bank's governing board spoke during the week on the impact of the financial crisis on the Swiss economy, but offered little new. The SNB believes that interest rates are currently "appropriate".

We still expect that the slowdown will be much milder in Switzerland than in Euroland, as is reflected in our latest exchange rate forecast, where we expect CHF to appreciate against DKK to 4.72 on a 3M horizon, 4.78 at 6M and 4.91 at 12M.

Key events of the week ahead

• Thursday brings retail sales data for March. The February figures surprised with a sharp increase, so it will be exciting to see whether Swiss consumers are still unperturbed by the turmoil in the financial sector.
• Thursday also sees another speech from the SNB's Thomas Jordan.

US: Will expensive oil burn tax cheques?

US tax authorities last week began paying out USD 106bn to consumers as part of the government's fiscal stimulus package. Payouts will stretch over almost three months and mean individual taxpayers receiving a cheque of either USD 300 or USD 600. Around 130 million people will have received a cheque by the middle of July.

The tax rebates were passed by Congress and the Bush administration in February in the hope that they would help mitigate the current financial and economic crisis. While there is little doubt the cheques will have a positive effect on consumption, there is much disagreement and uncertainty about the scale of the effect. One area of uncertainty is how much of the tax rebate will be added to savings. Studies looking at the most recent similar tax rebate, which occurred in 2001, suggested that between 20% and 60% of the tax rebate went directly to consumption. We expect that around a third of the tax rebate will be seen in consumption within six to nine months.

Another question is how much of the tax rebate will be eaten up by the recent increases in food and energy prices. This depends to some extent on the timescale one is looking at. When looking only at the period May to July, when the payouts will be made, food and energy prices equate to just 19% of the tax rebate. However, the effect on consumption will presumably stretch over both Q2 and Q3, at least. Assuming this, around 39% of the tax rebate will be eaten up by higher energy and food prices. Finally, as much as 73% of the tax rebate would be eroded if one considers the whole of 2008.

The conclusion is that the tax rebates will almost certainly boost consumption growth - perhaps significantly - over the summer, despite the increase in food and energy prices. However, looking over the year as a whole, much of the effect will be countered by the price increases in food and energy. That said, this does not mean that the tax package will not help - without it, consumption and hence the economy would have been hit even harder.

Key events of the week ahead

• Most important are the release of retail sales and consumer prices.
• Still too early to expect any tax-rebate effect on retail sales. We expect overall retail sales growth in April to be -0.3 % m/m and +0.1 % m/m excl. cars.
• Inflation will still be high in April at 0.4% m/m, or 4.0% y/y.

Asia: Surprisingly strong Japanese growth in Q1

Interest in Japan in the coming week will centre on the publication of the Q1 GDP figures. We predict GDP growth of 0.7% q/q in Q1, driven primarily by growth in housing investment (0.3pp), and further strong growth in net exports (0.2pp). We expect private consumption to grow by 0.5% q/q (boosting GDP growth by just over 0.1pp), which is slightly better than in Q4, but this is still the weakest part of the Japanese economy. The GDP growth of 0.9% q/q in Q4 was surprisingly strong, and we cannot rule out the possibility of this figure being revised downwards - in particular we are a little sceptical about the extraordinarily strong business investment initially reported for Q4.

Although Q1 is therefore looking quite healthy, it is important to stress that Japanese growth is set to weaken from here, dropping to around 0.3% q/q in H2 as export growth slows and the temporary boost from higher housing investment evaporates.

The past month has seen a marked shift in the market's interest rate expectations. The market now thinks that the next step from the Bank of Japan is most likely to be an increase in interest rates rather than a decrease, which was what much of the market believed in April (see chart). This shift comes on the back of economic data suggesting that Japanese growth has not collapsed after all, and a surprisingly strong rise in inflation to 1.2% y/y. Although we think the BoJ will indeed raise its rates in mid-2009, we believe the market has overreacted to the latest inflation figures. Inflation is still well within the BoJ's target range of 0-2%, and core inflation excluding energy and food is still a modest 0.1% y/y. We also expect inflation to drop back to 0.6% in 2009 as oil and food prices stabilise. As we have stressed before, we do not see inflation as a serious limiting factor for Japanese monetary policy. We believe that growth, not inflation, will be the key to the timing of the next interest rate hike in Japan.

Key events of the coming two weeks

• Monday brings Chinese inflation figures for April. We expect a slight drop due to falling food prices.
• Friday brings Q1 GDP data for Japan. We predict robust GDP growth of 0.7% q/q.
• The coming week also brings Chinese trade figures for April, which will finally give us an opportunity to assess the underlying strength of Chinese exports, as both the February and March figures were affected by the winter storms.

Foreign exchange: Has EUR/USD peaked?

More grief than glad tidings has generally been what the past week's economic data have brought. Euroland retail sales, Spanish consumer confidence and pending home sales in the US all fell to all-time lows, while the French trade deficit rose to a record high. The UK saw falling activity in the service sector and weakening consumer confidence. Meanwhile, Germany, Norway, Sweden and Hungary experienced declining industrial production, and in Australia, New Zealand and Switzerland unemployment rose.

More bad news than good is reflective of an economic cycle that is continuing to weaken. This is true of the industrial cycle, but even more so of consumption and housing. Industrial cycles are normally quite short (6-9 months), while housing cycles are long. The good news is that lower activity is often followed by falling inflation, and indeed inflation receded this week in Ireland, Spain and Switzerland. Unfortunately (from the inflation perspective), the past week saw new records for energy prices, with oil above USD 124. Not only do rising oil prices mean upward pressure on inflation, they also undermine consumption. However, rising oil prices should support NOK, and we continue to expect EUR/NOK to fall to 7.75.

From an FX perspective, economic cycles have an impact at a number of levels. In a declining economic cycle, AUD, CAD and GBP normally underperform CHF, EUR and JPY (see, eg, FX and the business cycle, 12 December 2007). This is of course a ceteris paribus postulation, but we nevertheless use it to shape our general stance. After the latest correction, we again expect that EUR/CHF is on the way down, towards 1.58 (CHF/DKK towards 4.72) in the first leg. Meanwhile, relative developments are often easier to relate to. The past week saw the clearest deterioration of the New Zealand labour market for almost 10 years. This, along with a number of other indicators, presents a relatively clear picture of an economy rapidly slowing. As was the case with GBP earlier, our view is that the combination of an overvalued currency, a substantial current account deficit and a turnaround in the monetary policy cycle points to a significant weakening of NZD in the coming months.

The impression of more bad news flowing out of Euroland than the US these days is also something that has not escaped the attention of FX markets, and after having reached a top of 1.6018, EUR/USD has fallen back to 1.5350 (USD/DKK has risen from 4.65 to 4.85). We have previously argued that a shift in expectations for the respective economic cycles should cause a fall in EUR/USD around the middle of the year. The question then is if the turnaround is now materialising. Unfortunately, the answer is not clear cut. We are pretty sure the eurozone's economy is deteriorating, and still expect that the ECB will cut interest rates after the summer holidays. However, we are less sure that the US is over the worst, even though the fiscal stimulus package will support consumption in the coming 2-3 months. The short version is that one should expect considerable noise on the line in the coming weeks, with the chance of a technically-based movement all the way down to 1.48 (USD/DKK 5.04). Following our target of 1.60 being reached in April, we have cut our 3M forecast to 1.55, and 6M forecast to 1.50. Our 1-year forecast remains at 1.50 (see Struggling between greed and fear, 5 May 2008).

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