Weekly Focus

Oil Prices May Not Have Peaked Yet

What was inconceivable just a couple of years ago is now everyday reality. Oil is trading at around USD 125/bbl. Prices have doubled in the last year - and we have not necessarily seen the end of it!

High energy and food prices are already a headache for the world's central banks, coming as they do at a time of stagnating growth, not least in the West. This week it was the Bank of England that sounded the alarm, warning that inflation will not permit interest rate cuts in the coming year despite weaker growth. In reality, though, the central banks' inflation problems are not necessarily yet over. Like everyone else, central banks are tending to assume that commodity prices have peaked, and that the direct effect on inflation will cease one year ahead. We share this view, and do not see commodity prices continuing to soar in 2009, although we do expect a slight overall increase.

But what if...? There is certainly no guarantee that oil prices have peaked. We are still seeing plenty of prob-lems on the supply side in the oil market, and demand in China and the Middle East just keeps on growing due to prices being kept artificially low through public sub-sidies. Nor is there any guarantee that demand for gasoline in the USA in the coming months during the all-important driving season will be as weak as many expect. If Americans choose to use their tax rebates to fill up their mobile homes and criss-cross the continent as they normally do, oil prices may very well climb fur-ther in the coming months. That said, we reckon that oil prices are approaching levels that will be harder and harder to explain on the basis of the fundamentals - so perhaps there is some hope.

Euroland: Euro-zone growth off to a good start in 2008 - but headwind ahead

The inflation and GDP numbers released in the past week showed that Euroland inflation is still high and that GDP growth was off to a good start in 2008. Not least the German GDP data surprised on the upside.

April inflation came out at 3.3%, down a little (0.3%-points) from March, when inflation numbers were influ-enced by the early Easter. Price increases were, not least, driven by rocketing oil prices and higher food prices. Energy prices surged by 10.8% y/y in April, lifting the rate of price increases by 1%-point. Mean-while, the core inflation rate has remained relatively high, at 2.4% in April against 2.7% in March. We ex-pect inflation to creep up a little over the summer. Uncertainty about oil prices is looming high but the price increases in recent weeks might push inflation up even further.

Euro-zone GDP grew surprisingly fast in Q1 2008, at 0.7% q/q and 2.2% y/y. Everything indicates that - like in previous quarters - GDP growth was driven especially by exports and fixed capital investment. Note, though, that the early Easter this year may have influenced growth numbers, and we expect this to have a knock-on effect on Q2 data.

The week ahead will give us a clearer picture of how the strong economic headwinds will affect the Euro-pean economy in the coming months, with the release of the German Ifo business survey and PMI numbers for the euro-zone. Both indicators normally give a good indication of economic developments. We expect GDP growth to slow in the coming quarters as the substantial headwinds (still strong euro, lower global growth, higher oil and food prices, and credit tightening) feed through into the European economy. Hence, we expect a number of weak reports in the coming 3-6 months.

Key events of the week ahead

• The German Ifo will set the agenda on Wednesday. Look for a modest fall.
• PMI data for the euro-zone are due out Friday. We expect manufacturing and, not least, services PMI to edge down a little further.
• Moreover, the coming week will see the release of Euroland industrial orders and the German ZEW indicator of business sentiment.

USA: Fed fears easing?

US economic data released over the past month have generally been a tad better than expected, and this trend continued in the past week, with April's retail sales and consumer prices. While retail sales fell 0.2% m/m as expected, there were a number of positive factors to be found in the report's details. First, the March figures were revised up; and second, underlying retail sales (excluding cars, petrol and construction materials) rose nicely for the second month in a row (see Flash Comment - US: Consumers not yet throwing in the towel). This, together with the lower-than-expected consumer price inflation of 0.2% m/m in April, will provide a firmer foundation for real private consumption in Q2.

Hence, our estimate for Q2 GDP growth of -0.5% q/q AR is probably a little on the low side - and our fears of a direct fall in GDP in Q2 will likely ease. Given also that the latest data suggest the prospect of a small upward revision in Q1 GDP growth from 0.5% to 0.9% q/q AR, the overall picture is a little more positive than expected, although the US economy is, nevertheless, experiencing a severe slowdown.

Both consumption and inflation data surprising positively may help smooth out the worry lines of the Fed members. There were already indications at the last FOMC meeting that the central bank might be close to going on hold, and the latest data may well reinforce this. The minutes of the meeting on 30 April will cer-tainly be closely scrutinised when they are released in the coming week for any hint of how close the central bank is to taking a break. The meeting minutes will also contain new forecasts on growth, inflation and un-employment from the individual central bank members. Besides the minutes, focus will be on the existing home sales data and the OFHEO house price index. We still expect home sales to stabilise around the mid-dle of the year, while prices will probably continue to fall well into 2009.

Key events of the week ahead

• Tuesday: Producer prices will increase by 0.5% m/m (0.2% m/m excluding food and energy) in April.
• Wednesday: Meeting minutes and new forecasts from the Federal Reserve.
• Thursday: House prices from OFHEO. We expect a fall of 1.1%.
• Friday: Existing home sales in April expected to fall by 1.9% to 4.84m annualised.

Asia: Japanese growth remains resilient in Q1

Japanese GDP growth in Q1 came out at 0.8% q/q, which was again better than expected (see Flash Com-ment - Japan: Strong Q1 GDP growth on improving domestic demand). Although growth in Q4 was revised downwards from 0.9% to 0.6% q/q, the overall impression is still that Japan has performed surprisingly well in recent quarters. It is still largely exports that are driving the Japanese economy, despite a sharp downturn in exports to the USA. Exports grew by 4.5% q/q in Q1, up from 2.6% q/q in Q4. Growth in exports to the rest of Asia and other emerging markets more than offset the downturn in exports to the USA. But it is not just exports that are driving the Japanese economy. Domestic demand has also moved into a slightly higher gear in recent quarters (see chart) - private domestic demand was behind 0.4pp of the GDP growth in Q1. Both private consumption and housing investment contributed to this stronger domestic demand, while business investment fell in Q1.

Nevertheless, we still believe that growth will slow significantly later this year as export growth drops to much lower levels, and the positive effect on growth from the normalisation of residential construction after the collapse in mid-2007 - following the introduction of tighter building regulations - evaporates. However, the strong GDP figures and the latest increase in inflation mean that the Bank of Japan will not need to sof-ten its tone further. The latest GDP data serve as a clear reminder that there are still both upside and downside risks in relation to the BoJ's forecast for GDP growth of 1.5% in fiscal 2008. The stage is there-fore set for a relatively drama-free monetary policy meeting in Japan in the coming week, where both we and the rest of the market expect the key rate to be left unchanged at 0.5%. The strong GDP figures will not prompt the bank to adopt a harsher tone. Until it can get a clear picture of the strength of the expected slowdown, the BoJ will stay on the fence and maintain a neutral bias in its monetary policy.

In China, the focus is currently on the aftermath of the earthquake that hit the southwest of the country dur-ing the week. The human cost has been considerable, but the economic consequences are expected to be limited, and probably far smaller than those of the snowstorms that hit southern China in January and Feb-ruary (see Flash Comment - China: Economic impact from earthquake expected to be limited). However, it may lead to a slight increase in inflationary pressure in the short term, mainly through increased activity in an already overheating construction sector.

Key events of the week ahead

• Tuesday brings a monetary policy meeting at the BoJ, which is expected to leave its key rate at 0.5%.
• Friday sees the publication of the minutes of the BoJ's monetary policy meeting on 8-9 April.
• No important Chinese data are expected in the com-ing week.

Foreign Exchange: From inflation to currencies

The top-three performing currencies in the past week have been HUF, BRL and CAD. Better-than-expected growth figures for Q1 were among the reasons for HUF firming more than 1% against EUR, while Brazil is benefiting from rising commodity prices and last week's upgrade to “investment-grade” by Standard & Poor's. We have a positive/neutral view on BRL against EUR, but are more sceptical about the sustainability of HUF performance. Meanwhile, at the bottom of the league we have MYR, NZD and INR, which have fallen between 2.5% and 3% against EUR. The fact that a number of Asian currencies excluding JPY (AXJ) have performed poorly this year is essentially a reflection of the economies concerned being vulnerable to the recent surge in commodity and energy prices. AXJ fundamentals are generally good: the currencies are generally undervalued, the current accounts are in surplus, and government borrowing requirements are moderate. Furthermore, the currencies of the region could be expected to rise on the back of any pick-up in the dollar. That said, increasing commodity prices are pulling in the other direction, especially in the case of KRW and PHP. Korea is extremely dependent on energy-heavy imports, and the external deficit is climbing. Politics is casting a pall over the Philippine economy, with fiscal responsibility in hasty retreat and the gov-ernment allowing a steep rise in public sector pay ahead of next year's election. Among the Asian curren-cies, we expect that SGD, MYR, THB and TWD will be the winners. The fall in NZD that was discussed in last week's Weekly Focus follows a further deterioration in the outlook for the New Zealand economy in the past week. We expect to see more Kiwi weakness going forward.

Rising commodity and energy prices are an important theme for the financial markets in general, but the ef-fects vary. Fixed-income markets have increased sharply in the past week (EUR 2-year swap rate has in-creased by 22bp, USD 33bp and GBP 44bp) at the same time as the curve has flattened. The movement re-flects a fear that increasing inflation will limit future rate cuts, although the flattening of the curve is also consistent with the market not fearing that the inflation surge will be long-lasting. This is also apparent in the market pricing of implied inflation.

On the FX markets, there is currently not a direct link between relative yield movements and currency movements. For example, the steep increase in UK yields has not led to a stronger GBP. Meanwhile, the most notable point in Wednesday's quarterly Inflation Report from the Bank of England was the expectation that inflation will now jump to 3.7% in Q4, compared to February's expectation of 2.7%. If the bank's fore-cast is correct, cutting interest rates will be problematic in the coming months. On the other hand, the need for a more accommodative monetary policy was highlighted in the past week by the fall in retail sales and a serious deterioration in the prospects for the housing market. The result is a more negative outcome for the UK's economy in the longer term - and a slide in sterling. Indeed, we expect further GBP weakness in the coming weeks. Generally speaking, the decisive factor is to what extent a restrictive monetary policy, as a result of rising inflation, will be supported by the state of the economy. With the surprisingly strong growth figures from the euro zone in the past week in mind, it is easier to understand why the euro has strength-ened against, for instance, GBP and CHF, and we would not recommend selling EUR/USD before Europe's economic downturn is more advanced (see also EUR/USD: Will history repeat itself?).

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