Global Scenarios: Trends and Risks

• The global industrial slowdown will mature further early in 2007
  • increasingly spreading to Europe and Asia
• The US construction sector is still in recession
  • but consumer demand will re-accelerate in the coming months
• Germany has prevented a significant slowdown in Europe
  • but further slowing is on the agenda in 2007
• Asian economies are slowing
  • but will continue to grow in a lower gear
• Further monetary policy tightening is on the cards
  • in Europe, Japan and, by late H1, also in the US

Introduction: While the US shows, Europe slows

• Along with a slowing US economy the global industrial slowdown has matured further in the autumn. While we expect the global industrial cycle to edge further down in the coming months, resilient domestic demand growth in Europe and the US will prevent the industrial downturn from developing into a more pronounced global growth slowdown.
• Large regional differences between the US and Euroland have emerged during the autumn. While US industrial indicators and growth have slowed, Euroland data has remained remarkably strong. The present market pricing suggests that this picture of Euroland outperforming the US will continue into 2007.
• However, contrary to the market, we think it is too early for a slump in the US. Strong real wage growth and a beginning of stabilisation in the housing market will provide an upside surprise in growth during Q4 and Q1. Combined with a continued uptrend in core CPI inflation, this will set the stage for several additional Fed hikes during 2007.
• Euroland, on the other hand, will see a negative surprise as we enter 2007 - at least compared to the US. We suspect that the upcoming VAT hike has prolonged and amplified the industrial upswing. However, the VAT hike and the slower global industrial environment during the autumn will kick back in early 2007, resulting in a weakening of Euroland industrial growth indicators. This will pave the way for a pause in the ECB hiking cycle. Consequently, there is a relative surprise in the growth picture in the pipeline.
• In Asia the growth picture has become somewhat softer. In Japan growth has slowed, led by sluggish consumer spending, and in China the tightening campaign and the slowing global industry has begun to show its impact. However, we don't expect the current slowing in Asia to develop into a more serious slowdown as the structural recovery in Japan and the catch-up process in China will continue.

A 2007 surprise is brewing

Global industry is slowing, but less in Euroland

Since May we have emphasized that one of the main themes this autumn would be the slowing in global industry. As we have argued, this slowing is mainly related to a slowdown in global trade and a downward correction in global inventories.

We also emphasised that underlying domestic demand in all three major regions is likely to slow only modestly and that the current industrial downturn would not develop into a serious global slump. On the contrary, resilient underlying demand will keep the global expansion going, leading to a rebound in global industry during mid- 2007. We still hold these views, with the minor adjustment that the industrial downturn now looks to become a bit more prolonged than we had initially anticipated.

While the picture of global industry losing momentum and domestic demand remaining robust complies with our message from Global Scenarios September, we have been somewhat surprised by the size of the regional differences.

While the US ISM has slowed consistently from its peak in the late spring - broadly following our forecast - we have barely seen any easing in Euroland PMI. We believe that the divergence this autumn has primarily been driven by lagged stimuli to the two regions and possibly big ticket spending in Germany due to the upcoming VAT hike. To a lesser extent, the divergence also results from the significant US housing slowdown, and from a more fundamental improvement in German economic trends.

Markets are wrong about US vs Euroland outlook

At present, this picture is reflected in financial market pricing. Markets are telling us that, in the US, growth will be slowing in 2007, thus paving the way for Fed cuts in spring. At the same time, the market thinks the ECB will pause after an additional rate hike in December - and perhaps Q1. Implicitly this is the story of a global slowdown, but one that is centred on the US - presumably with the US housing market playing a prominent role.

As always, the task for investors is to look at what the markets are telling them - and think differently. In our view, there are two major ways in which you should think differently now.

It is still too early for a big US slump

Firstly, the market underestimates the outlook for US growth and core inflation in 2007. As we show in USA, there is a strong case for a pick-up in consumption growth in the coming months, driven by the surge in real income growth.

Moreover, the housing market data shows all the usual signs of stabilisation: Sales of new homes have been flat for more than six months. Housing starts has been sufficiently below new home sales to see inventories of unsold homes falling over the past three months. This implies that the drag on growth from the residential construction sector is set to diminish from now on.

Surely weakness in house prices is a drag for consumer spending growth, which will stay with us into 2007. At least when compared to the strength from recent years. However, the acceleration of real income growth - to above 4% y/y - looks strong enough to counter the negative impact from the slowing housing market.

Finally, US core inflation is on a fundamental - albeit slow - uptrend. The recent slowdowns in core PPI and core CPI inflation are likely to prove just as temporary as the slowdown in core inflation in 2005. Moreover, the uptrend in inflation is not likely to disappear before the next US recession.

In this environment rate cuts are not likely to materialise. On the contrary we think the Fed will be forced to hike the fed funds rate several times in 2007.

Euroland is going to slow

The second area in which investors should think differently is when it comes to the relative European/US growth picture. As the chart below shows, the relative steepness of the US and European money market curves is rather large. Moreover, the relative steepness is closely linked to the relative levels of industrial growth indicators, such as the difference between the Euroland PMI and the US ISM index.

Presently the market seems convinced that Euroland will be sheltered from the current industrial slowdown. However, this view is likely to be as illusionary now as it was in 2000. The global industrial sector has hardly become less interdependent since 2000.

Contrary to the US, where much of the adjustment in the industrial sector has already taken place, the Euroland industry has barely slowed as German industry has remained remarkably resilient during the autumn. While some this recent strength could be a reflection of the maturing structural recovery in Germany, we suspect that the main explanation is to find in the introduction of a German VAT hike of 3% on January 1, 2007.

Just as the VAT hike is currently boosting the European industrial, it is likely to do the opposite as we enter 2007. Hence, the VAT hike will postpone and exacerbate the downturn in European industry (see our report Research Germany: VAT rollercoaster - but recovery intact from October 30).

While we think that the Euroland economy is only heading for a mild slowdown, the reaction in European PMIs is likely, as always, to overshoot. From this perspective we think that Europe will deliver a negative surprise vis-à-vis the US (see Euroland).

The chart above shows our +6M forecasting model for the relative level of Euroland PMI compared to the US ISM. The model has been rather good so far at forecasting turns in the relative strength of Euroland. And the direction going forward is clear: European industrial indicators will start to underperform US ones during spring 2007.

Hence, a case is building, in our view, for being long European bonds against US ones.

Asia slowing down too

One development that is surprising us at the moment is the weakness in Japanese consumer spending. While Japanese data can be volatile and hard to interpret, they are showing a slowdown in consumer spending, led by car sales (see Asia). We still see this weakness as temporary, as the fundamental drivers of Japanese consumption - including the labour market - remain broadly supportive. However, Japan does appear to be losing some steam, which is also reflected in the underperformance of NIKKEI225 vis-à-vis the US S&P500 index over recent months.

In China, the economy is also showing signs of slowing from its breakneck growth pace. This is a response to the slowing of the industrial cycle and the tightening of credit conditions and fiscal policy. However, we continue to see the instruments used by Beijing to reign in growth as rather inefficient, and we do not think a serious slump is in the pipeline here either, at least not given our rather sanguine view on US growth in early 2007.

Our 3-month key variable predictions

USA: Fed waiting for visibility to improve

• Following a strong beginning of the year US GDP growth has slowed during recent quarters as the slump in the construction sector has matured further and the manufacturing industry has softened. However, the sharp drop in energy prices, a rallying stock market, lower real long-term bond yields and a Fed on hold will provide oxygen for a growth rebound heading into 2007.
• The recent drop in energy prices will lead to a significant near-term reacceleration in US consumption. Generally, we expect the US consumer to remain resilient during 2007, as a tight labour market is translating into high wage growth and we don't expect any significant negative wealth effects as we expect house prices to stabilise and stock markets to stay rather strong.
• The major driver behind the current growth slowdown - the construction sector - will improve gradually during 2007. There are now tentative signs of a stabilisation in housing demand, implying that we expect the construction sector to reach a trough during Q4. During late H1, we expect the consumer demand reacceleration, lower energy prices and run down inventories to kick positively into the industrial sector implying rising ISM by then.
• Wage and price pressures are still elevated, although core CPI inflation has eased marginally since the highs during summer. Going forward, we continue to see a gradual upward drift in core inflation as a tight labour market and second round effects from the rise in commodity prices.
• The recent slowing in growth and slightly softer inflation figures have bought the Fed some time, and we expect it to remain on hold until visibility improves in late H1. However, we still see a need for further policy firming during next year and expect the Fed funds rate to reach 6% by end-2007.

Steaming up

Loosing steam... but only for a while

Following very strong growth in Q1, the US economy has been loosing momentum during the recent quarters as the slump in the US construction sector has matured further.

While the current slowdown in US growth has proved a notch deeper, and longer than we anticipated in Global Scenarios, September 2006, our call for the US economy is quite similar this time.

Financial conditions have generally been easing during second half, with lower real interest rates, lower energy prices and a booming stock market, c.f. above. In the near term, these factors will help counter-weigh some of the negative impact from the slump in the housing market and during the coming quarters we expect the US economy to regain traction and reaccelerate back to growth of around 3%, core inflation to edge above a 3% high and the Fed to restart the tightening cycle during 2007.

Private consumption reaccelerating

As we emphasized in Global Scenarios, September 2006, the main driver of a rebound in GDP growth will be a reacceleration in US consumer spending during Q4 and Q1 to a 3.5-4% pace and a continued robust performance during 2007 as a whole.

There are two major arguments behind this view. Firstly, the sharp drop in energy prices during the autumn has boosted real incomes by more than 1.5%. Secondly, the tight labour market is now showing up as a pick-up in wage growth.

As we expect the labour market to remain tight and see only a slight increase in the oil price, the current pattern of high real income growth should prevail averaging 4% during 2007. Given the benign income situation we expect a rise of 3.2% in consumer spending.

Even this solid spending forecast will leave room for a solid rise in the savings rate by 0.8%-point during 2007. According to our savings rate model two major factors will imply a rise in the savings rate. Firstly, more subdued wealth effects due to slower house price growth and lagged effects from short real rates will drive a small increase in the savings rate. Secondly, and equally important, the rise in the savings rate will be a natural response to the sharp pick-up in real income growth (partly due to the drop in energy prices) and lower unemployment, as consumers tend to smooth their outlays over time (see "income & employment" in the table below).

The bottom line is that it is difficult to see a see private consumption spending stalling anytime soon even allowing for an unusual big negative wealth effect stemming from house prices. A 2% real consumer spending forecast consequently implies a 2 %-point increase in the savings rate during 2007. Given our baseline forecast such an outcome would take an approximate drop of 5% in aggregate housing wealth during 2007 - a scenario which we would find rather unlikely, especially as we are now seeing a tentative trough in the housing market.

Reaching a bottom in the housing market

During Q3, the slowdown in US residential construction subtracted more than 1%-point from GDP growth.

While we expect a similar rough ride during Q4, there are now several tentative signs that the US housing market is about to reach a trough. Consequently, we expect that new home sales will stabilise around the current level during the coming months (see "Research USA: US housing bottoming out", October 17 2006 and "Flash Comment - USA: Home builder sentiment rises again", November 17 2006).

If we are right the negative growth impact from the construction sector will gradually abate and turn neutral by end-2007, c.f. the chart above. This will boost GDP growth by 1%-point during 2007.

A stabilisation in new home sales will be positive news for house prices as well. House price growth has been slowing faster than we initially thought and some of the more volatile indices, such as new and existing home sales median prices, have moved into negative territory in annual growth rates. However, the more comprehensive OFHEO index has continued to show increasing house prices.

Going forward we don't see annual OFHEO home price growth turning negative, though the pace of appreciation is definitely slowing fast. A stabilisation of new home sales around the current level will imply that the underlying trend real home price appreciation remains well above zero in the 3-6% range, c.f. the chart above. This means that house prices will not slow enough to generate a seriously negative wealth effect for the US consumer in 2007.

US industry taking a breather

The US economy is not only struggling with the slowdown in the construction sector. Since late spring the US industry has been slowing. From its peak at 58.1 in May the ISM index has edged down to 51.2 in November - a little below our 52 target from Global Scenarios, September 2006.

During the coming 3-4 months, we expect little change in the ISM index, though we could see a short-term rebound in October and December (see "Flash Comment - USA: ISM down, but trough is near", a November 1, 2006). However, we set our target for ISM in February at 51.

Looking further into 2007, the effect from lower energy prices, the consequent reacceleration in goods demand, and a completion of the inventory adjustment, will start feeding positively into the US industrial cycle.

However, as there are still counter weighing lagged effects from tighter financial conditions and higher core inflation in the industrial pipeline, we cannot rule out that the ISM index could dip temporarily below 50. That said, we expect positive forces from cheaper energy and higher demand growth to ultimately prevail, implying a pick-up in the ISM index during late H1next year.

Decent 2007 - troubles may appear in late 2008

With a reacceleration in consumer spending, continued robust business spending, waning drag from the construction sector, and a pick-up in the industrial cycle, we expect 2007 to become a quite decent year for the US - at least better than what the market and the majority of analysts are currently expecting.

Looking into 2008, much depends on the behaviour of the Federal Reserve. The longer the central bank stays on hold, the more oxygen it will provide for the expansion to keep running. Hence, with the Fed probably on hold well into 2007, we don't expect any serious downturn in growth for a considerable period of time.

This is supported by our recession probit model, which shows zero probability of a US recession within the coming 6-12 months (see "Research USA: The risk of a US recession").

However, when the Fed (as we expect) resumes hiking later in 2007, and possibly into 2008, taking monetary policy to a tight stance, it will most likely lead to broad tightening in financial conditions. This could spell more severe troubles for the economy somewhere late in 2008.

Prolonging the Fed pause

Inflation will continue to haunt at the Fed...

So far this year, tight labour and product markets have translated into increasing wage and prices pressures. Core CPI/PCE inflation have picked up from 2.2% y/y to recently 2.7% y/y and unit labour costs growth have been rising from 1.6% y/y to 5.2% y/y.

While inflation pressures have seemingly eased somewhat since summer, labour market pressures have mounted further. Generally, we do not see the recent data as a proof that inflation is about to trend lower.

A still tighter labour market and hefty pipeline price pressures waiting to pass through in the PPI (i.e. second round effects from higher commodity prices) will imply that core inflation drifts above 3% during Q1 next year. Moreover, we see a very limited potential for near-term easing in the wage pressures during the coming quarters as unemployment has recently continued to edge down. It will take a rather serious and long-lasting slowdown in GDP growth to remove labour market wage pressures (see "Research USA: Core inflation reaching 10-year high").

... eventually leading to further policy firming

While the Fed has been on hold since August, they have continued to retain their bias toward further tightening if not core inflation ease sufficiently fast (see "Flash Comment - USA: Still on hold with a tightening bias").

However, until now the developments since August have broadly confirmed the scenario presented by Fed at that time; growth has slowed and the impulses to core inflation have eased off. In that sense, the Federal Reserve has bought itself some additional time, and generally, FOMC members seem quite satisfied with the current stance of monetary policy.

Based on the recent comments from the Fed and the fact that the current growth slowdown has been a notch deeper and more prolonged than we initially anticipated, we have postponed the resumption of the hiking cycle until the June 28 meeting next year. At that time, we expect that the US economy to have picked-up again, and core CPI inflation to have moved above 3%, which will force the Fed into a resumption of the hiking cycle.

Euroland: Slowing in spring

• The pent-up investment recovery in Germany is continuing at full speed, ignoring the global industrial slowdown. The solidity of the German recovery has prevented a significant slowing of Euroland growth this autumn.
• There are three separate elements in the Euroland business cycle, which we believe deserve independent interpretation. Firstly, the underlying pace of domestic demand; secondly, the externally driven industrial cycle; and thirdly, VAT related disturbances to economic growth.
• The underlying, domestic recovery has to date solely been an investment recovery. However, the stagnation of housing in some Euroland countries along with the loss of purchasing power stemming from the German VAT rise next year are likely to be more than offset by rising real incomes due to stronger wage growth, lower oil price and continued strong labour market performance. As such, consumer demand growth looks set to be robust in 2007.
• The external stimuli to the Euroland economy will continue to fade, as global industry is set to lose further steam over the next half year, and as the relative advantage of Euroland industry compared to global industry wanes through the first half of next year. The German VAT boom bust scenario will prevent business confidence from falling for the next couple of months, but will also exacerbate the likelihood of a fall in business confidence by spring next year. By next summer we expect business confidence in Euroland's economy to have fallen to around average or even just below.
• This fall in business confidence will be interpreted as a significant cooling by markets, but it is mainly the result of corrections in inventories and net exports, and we expect the impact on domestic final demand to be only minor. Indeed, we do not expect strong lasting effects from the VAT hike on Germany consumers. Thus, a little re-acceleration of the economy is on the cards in late 2007 and into 2008, where growth is likely to rise to a little above average.
• Only the German VAT rise will prevent overall Euroland CPI from falling below 2% next year given current oil prices. While some limited second round effects will slowly feed through, core inflation excluding the German VAT hike will not rise above 2%. The outlook for 2008 is for inflation to be around or slightly below 2%.
• The ECB is still pushing for a normalisation of monetary policy to 4.0%. We expect the ECB to hike rates twice in 2007. The timing of the second hike is uncertain. As of now we favour the ECB pausing during spring and summer. If the economy is not too damaged by next summer, and if the euro does not strengthen too much, late 2007 and 2008 will offer a few additional hikes bringing policy to a significant restrictive stance.

Surprisingly robust recovery

Ignoring the global slowdown?

After an impressive first half of this year, Euroland GDP growth eased in Q3 back to trend: That is 2% annualised growth. However, business confidence and preliminary GDP details suggest that underlying growth is a bit better.

Thus, the slowing of global industry has to date only done minimal damage to Euroland industry. While the momentum in Euroland exports has slowed throughout 2006, the overall manufacturing sector in Euroland has proved more robust. Exports are usually the main driver of the momentum in the overall manufacturing sector in Euroland, but this has not been the case lately, as outlined in the chart below.

Is the German locomotive back?

The real surprise is that the German economy hardly seems to have softened. It is true that headline GDP growth came down to 2.5% ann. in Q3 from 3.75% in H1-2006, but the ifo index has re-captured the loss it saw through the summer, and domestic demand growth only eased from 3.4% annualised in H1-2006 to 2.9% annualised in Q3. This compares to a softening of domestic demand in the rest of Euroland from 2.9% annualised growth in H1-2006 to an estimated 2.2% annualised in Q3. In particular, the Germany investment recovery has been strong. German capital orders for the domestic market are growing at their strongest pace since reunification. While since last summer we have been optimistic on the chances that the domestic economy could finally get started in Germany, we have been surprised to see this kind of dynamic.

Thus, in spite of slowing exports momentum in Euroland, the domestic investment recovery in Germany has kept the overall industry in Euroland on fire this autumn. In the chart above, we have estimated Euroland industrial production on Euroland exports and German domestic capital orders. These two variables describe most of the dynamics in total industrial production. From the contributions, also shown in the chart, it is clear to see that German capital orders for the domestic market are contributing strongly to industrial production at the moment.

As such, there is little doubt that the rise of the German economy has played an important role in neutralising the negative impulses from abroad. In our view, the strength of the German economy through 2006 is partly the result of the more "structural impacts" from the construction sector, the labour market and the corporate sector. These factors will continue in the coming years, as highlighted in our research notes: "Research Germany: Construction bottoming out", of October 14, 2005, and "Research Germany: Finally a year of recovery" from January 5.

However, this is not to say that Germany and Euroland can isolate themselves completely from the softer global industry. In fact, we believe that a substantial part of the German strength in 2006 has also been of more cyclical nature.

Relative shocks explain a lot

In previous editions of Global Scenarios, see for instance the February 2005 and November 2005 editions, we argued why Germany saw a slow start to the global recovery in 2003 and 2004 but would do better than the US economy through 2006. The reasons for the huge time delay in the German recovery compared to the US ditto is primarily due to the fact that the two eocnomies have faced very different financial and economic shocks over the past four years.

The difference in shocks between the US and Germany from monetary policy, fiscal policy, equities, long interest rates and FX movements suggested the largest underperformance of the German economy in 2003 and 2004 when compared to the US. Through 2005 and 2006, these shocks turned in Germany's favour, as the ECB left its policy on hold for an extended period of time compared to the Fed, as the euro weakened and as fiscal policy was more similar across regions. Based on these considerations, one would indeed expect German business confidence to outpace that of the US right now, see chart below.

This correlation is, of course, not very exact, neither in amplitude nor timing, but it does capture the broad trends. The chart above suggests that the relative outperformance of the US would peak during 2004, as pretty much occurred. The chart also suggests that the strong outperformance of the German ifo index compared to the US ISM manufacturing index should peak around New Year 2006/2007 - that is now.

Gearing down and then up a little

The dynamics of the Euroland recovery

The chart above also gives a clear signal for the relative performance through 2007. While the year will start with German and Euroland outperformance of the US, the year is likely to end the other way around. As we write in the chapter on the US, we expect US business confidence to bottom out by next summer.

Thus, Germany and Euroland will probably face two kinds of headwinds in H1 2007. Firstly, global industry will gear further down, although only very slowly. Secondly, Euroland industry will lose in terms of its relative advantage compared to global industry - a trend that is likely to continue throughout 2007. As such, the bottom line for Euroland/German industry and business confidence is substantial headwinds until next summer. We are thus looking for Euroland business confidence to fall to average or just below average by next summer. This picture will be consistent with the dynamics of the Euroland recovery to date. The recovery has been volatile due to global industrial fluctuations, which have created substantial volatility in net exports and inventories. This has disguised the slow build of the recovery in domestic demand over the latest four years, as shown in the chart below.

We do not expect domestic demand growth to be damaged much by the fall in business confidence and headline GDP growth in H1 2007.

In the second half of next year, global industry is likely to re-accelerate, but the relative picture does not favour Germany and Euroland. Thus, the overall picture looks relatively blurry. On balance, we tend to believe that we will see some slight reacceleration of the Euroland economy late next year and into 2008. This could be derailed by a new significant strengthening of the euro.

Added German VAT volatility

On top of these developments, we expect the German VAT rise to create a significant boom and bust scenario in the final months of this year and in the first months of 2007, see "Research Germany: "German VAT roller coaster" from October 17. As a minimum, we expect German consumer demand in the national account statistics to rise by some 1.5%q/q in Q4 before falling some 1.75%q/q in Q1. This is equivalent to a total effect on German GDP of about +0.75%-points in Q4 and close to - 1.0%-points in Q1. However, these reactions are based on historical VAT hikes of each 1%-point. Thus, this time around, when the VAT hike is of the 3%-points size, the effect could very well be larger. We have indicated this uncertainty interval tentatively in the table below.

The VAT hike will also be visible in business confidence. We believe that German business confidence will look better than otherwise in November, December, and January next year. On the other hand, business confidence will probably fall significantly through the rest of H1 2007. Finally, regarding the VAT hike, we believe it will not lead to any marked longer term consumer demand reaction in Germany. The lower oil price, and higher wage and employment growth will neutralise the effects from the VAT hike, as shown in the chart below.

Inflation and the ECB

Limited second round effects building

Since last autumn we have been sceptical that there would be any significant second round effects in core inflation. Since then, core inflation has eased with the come back ending at exactly the same level as a year ago. It covers further slowing of service price inflation, while core goods inflation has risen slightly. Over the coming year, second round effects will continue to build slowly, see our "Research Euroland: Could inflation hit 3%?" note of August 25. We expect Euroland core inflation excluding VAT to rise from around 1.5%y/y to 1.75-2.0% within the coming 12 months.

However, core inflation looks set to ease a little again in 2008 unless the oil price rises again or wage growth rises more than anticipated. Thus, only the German VAT rise will force headline inflation above 2% next year given stable oil prices.

Wage growth remains the major point of uncertainty; see our "Research Euroland: Labour boom without much inflation" note of May 5 this year. With higher consumer inflation expectations and a labour market that is slowly tightening, wage growth could rise strongly. However, given the historical low wage inflation in Euroland, there is scope for some rise in wage growth without any danger to inflation. Therefore, we expect that ECB inflation forecasts for 2008, which will assume some wage acceleration, to amount to 1.9-2.0%.

ECB aiming for 4%

The ECB is aiming for 4% in order to normalise monetary policy, and this is where we expect ECB to be on a 12-month horizon. The exact course of policy is uncertain. We believe they will hike once more in Q1, reaching 3.75%. Whether the ECB will hike again in Q2 or wait until growth picks up again late 2007 and into 2008 is a close call. The oil price, the euro and the weakening of business confidence during H1- 2007 will determine ECB action. On balance, we favour the scenario that the ECB takes a wait-and see approach thus being on pause from Q2 and until late 2007 or early 2008. In all circumstances it is fair to say that the ECB is now going for a relatively tight policy, see chart below.

Asia: Is it slowing?

• The weak Japanese private consumption indicators over the past months raise the question whether Japan's recovery is coming to an end. We argue that one reason for the weak Japanese consumption has been that the tightness of the labour market has not translated into significant wage pressure. Moreover, Japan's industry may face further headwind in the coming months as global industry slows.
• However, we do not expect this to be the end of the Japanese recovery. This is because: 1) the slowdown in the global economy will not be dramatic; and 2) the structural changes of the Japanese economy still have to feed fully into the economy. Slight inflationary pressure and a still relatively solid economy will pave the way for the BoJ to hike interest rates three times in 2007 - the first time in Q1.
• We expect that the Chinese economy is slowing. Chinese industry is being hit on two fronts: from the tightening of the monetary/credit policy since April, and the slowing global industry. However, we do not expect the slowdown to be dramatic as the global economy will do relatively well and the effectiveness of China's monetary/credit instruments tends to fade out relatively quickly.
• We expect that the renminbi will continue the appreciation trend that we have seen over the past months, approaching 7.45 in one year's time, in our view. The reasons are a ballooning trade surplus and protectionism remaining high on the agenda in the EU and the US.

Is the Japanese recovery faltering?

What to make of private consumption?

Over the past months, Japan's weak private consumption indicators have grabbed the headlines. In Q3 private consumption fell 1% q/q pulling down annualised GDP growth by 0.5 percentage points. Bank of Japan has dismissed the data arguing that it is just a temporary phenomenon due to adverse weather conditions. But is this the first sign that the domestic recovery of the Japanese economy is approaching an end?

Over the last years economists have argued that the tighter labour market, which will eventually translate into higher wages, will put a floor under Japanese consumer spending. The problem is, however, that until now the tightness of the labour market has not translated into significant wage pressures. Japanese companies are, perhaps due to a decade of sluggish growth and rising Chinese competition, apparently able to fight off wage pressures despite huge profit growth.

Moreover, although the labour market has tightened, employment has not risen strongly even when taking into account the increase in part-time workers. Finally, historically the transmission from higher wages to rising private consumption is not as clear cut in Japan as in many other countries e.g. the US.

Instead, Japanese private consumption tends to be affected hugely by the cyclicality of the industry and export growth. The Japanese industry has until now been remarkably resilient to the slowing global industry but as the US industrial slowdown is accompanied by a similar development in China (see below), the Japanese industry and hence export growth will be hurt.

Riding out the storm

Will this be the end of the Japanese recovery as weak consumption is accompanied by a slowing industry? Not in our view. First, as argued above, the US economy will still grow close to trend in 2007 and the global industry will bottom out at the end of H1 2007. Second, the slowdown in China, which is Japan's biggest trading partner, will not be dramatic (see below). This implies that the Japanese industry may in fact get a new boost from the global economic conditions during 2007. Finally, the structural changes in the Japanese economy are still at play. The potential from the shift from asset deflation to asset inflation and the cleaning up of the banking sector is enormous and still has to feed fully through into the economy.

Therefore, we do believe that the Japanese economy will do relatively fine in 2007, probably growing a bit above trend growth. We have lowered our forecast for 2007 from 2% y/y to 1.9% y/y. We maintain our call that the BoJ will hike in Q1 2007. We do not expect a hike in the next month as inflation is too weak and there is still some uncertainty about the private consumption indicators. However, as soon as the private consumption indicators stabilise and inflation continues its slight upward trend, the BoJ will hike. We also stick to our relatively aggressive call that the BoJ will hike two times more in 2007 ending the year at an interest rate of 1%. Slight inflationary pressure and a still solid economy will be enough for BoJ to move further to normalise monetary policy.

Has the Chinese slowdown finally arrived?

Is it for real?

Over the past few years many economists have predicted that the Chinese economy was about to slow down but until now they have been proven wrong. However, as we wrote in our Flash Comment - China: Early signs of industrial slowdown, November 15, the latest economic indicators do suggest that the Chinese industry is heading southwards. Admittedly, we only have very few data: import and industrial production data from October and a drop in investment growth over the last months. But the Chinese industry is now being hit on two fronts: by the tightening of the monetary/credit policy since April and by the slowing global industry.

Therefore it is only natural that we see a slowdown in the Chinese industry. However, the crucial question remains: how serious will the Chinese slowdown be and is there a risk of a hard landing?

We do not expect the Chinese slowdown to be very dramatic. First, we expect that the US economy will do fine and the global industry will bottom out at the end of H1. Second, any further signs that the Chinese economy is slowing will make the Chinese authorities reluctant to introduce further monetary/credit tightening. Third, the effectiveness of China's monetary/credit instruments tend to fade out relatively quickly. The increase in money supply growth in October may be a first sign that the tightening measures are already losing their bite.

Unless the US economy goes into recession we do not expect a hard landing for the Chinese economy. We believe that there is a strong momentum in China's investments that will not burst even if export growth slows to say 15% y/y. More than 50% of China's investments are in industries that are not directly exposed to the export sector. Moreover, although the financial system in China is rotten, there is no risk of a near-term financial meltdown as the banking sector is effectively backed by the state. (see Research - Global: China's growth miracles - is it sustainable? from November 21 for a more in depth discussion)

Where does this leave us? We expect growth to slow to around 9% y/y in 2007 down from around 10.5% y/y in 2006. That implies that China will continue to be a growth driver for the world economy in 2007. And probably more than ever given that the US, Japan and Euroland will grow at a lower speed than in the last few years.

Continuing faster appreciation

What about the currency, which continues to attract a lot of attention? Over the last three months we have seen a speeding up of the appreciation trend and more volatility in the renminbi versus the dollar. We think the main reasons have been: 1) more confidence in the currency system after a trial period of more than a one year, 2) a still very fast growing economy which implies that the Chinese authorities have had the room to move faster on the currency and 3) political pressure as protectionism is still high on the agenda both in the US and the EU.

Where will China go from now? We think it will continue at the speed we have seen over the last three months but allowing for more two-side volatility. The main reason is the ballooning trade surplus that continues to create political friction. Therefore we forecast that USD/CNY will be 7.45 in one year's time. One downside risk to our forecast is a dramatic slowdown of the economy as the Chinese authorities would be more reluctant to allow for a fast appreciation.

Alternative 1: Genie out of the bottle

• The long-lasting decline in inflation has come to an end. Five years of global expansion in the wake of a period of unusually easy monetary policy conditions has fuelled global inflationary pressures. The recent trend of rising underlying inflation proves sustained and difficult to quell.
• Conditions in labour and product markets fail to ease as US growth recovers and the structural recoveries in Germany and Japan continue. This leads to further acceleration of inflation and a selfpropelling increase in inflation expectations. Global central bankers find themselves in a behind-thecurve scenario, with an urgent need to tighten monetary policy.
• The cost of quelling inflation has risen by now, and global monetary conditions need to be tight. Central banks must engineer a hard landing to bring inflation under control. Consequently, the pace of economic growth slows dramatically during late 2007 and into 2008.
• Ramifications in asset markets are significant. Bond yields rise as markets price in higher inflation premiums and the period of ample liquidity draws to a close. Equity markets suffer as well, and especially emerging markets are hit, since they have benefited the most from awash-with-cash conditions. Housing markets take another beating, and global home prices drop significantly.
• Global economic growth remains subdued for a prolonged period and might even reach a recessionary state. Monetary policy is not loosened until the inflation threat has receded.

Back to the 70s and 80s

Entering a vicious circle

The recent pick-up in global inflation - especially in the US - proves sustained and very difficult to quell. As US growth recovers and the structural recovery in Euroland and Japan continues, labour and product markets tighten even further.

Central bankers realise that they have failed to respond adequately to the early warning signals from global product and labour markets, and they find themselves in a behind-the-curve scenario. Wage pressures are still mounting, commodity prices continue to rise, core inflation increases further and - worst of all - inflation expectations fail to resist upward pressures.

Higher inflation expectations have dramatically increased the cost of bringing inflation back under control. With global economic growth still running lose to - or even above - trend, an urgent need for a significant policy tightening arises. Central banks are forced to engineer a hard landing to break the vicious inflation circle, and the pace of economic growth slows significantly during late 2007 and into 2008.

Ramifications in asset market are significant, and the first signs of a deeper and more prolonged correction emerge during spring.

Bond yields shoot up dramatically as the markets price in higher inflation premiums and the significant tightening of monetary policy ends the period of ample liquidity. The global financial markets are no longer awash with cash.

Equity and commodity markets suffer equally hard and emerging markets are hit, as they have been benefiting the most from low risk aversion and ample liquidity. The cooling in global housing markets accelerates, and global home prices fall significantly.

Global economic growth remains subdued for a considerable period of time, as central banks do not wish to loosen their grip until the inflation threat has receded. Late in 2008, the inflation picture starts to improve, as the slowdown has now created sufficient slack in labour and commodity markets. Monetary policy is loosened, and signs of recovery mature as we enter 2009.

Alternative 2: Housing crunch

• The global expansion has peaked along with the industrial cycle. Hence, the global economy is in for a rough ride, with a significant slowdown in the US leading the way.
• Despite the large drop in oil prices, US growth fails to recover, as the housing slowdown deepens further and eventually spills into a broader economic slowdown. Significant job losses and plummeting home prices make a hard landing inevitable.
• Even though the structural recoveries in Japan and Euroland have strengthened, the two regions cannot resist the slowdown in the US. Global demand and global industry slow significantly and PMIs dip below neutral levels. Fears of a global recession increase dramatically.
• Given the elevated inflationary pressures, central banks are initially reluctant to ease policy, but as the slowdown matures, monetary policy is finally loosened. Slower growth gradually dampens inflationary pressures as labour and commodity markets slacken.
• Reactions in asset markets are asymmetric. Bond markets benefit from easier monetary policies and receding inflationary pressures as growth slows. However, equity and commodity markets take a beating. Emerging markets suffer by far the most as higher risk aversion kicks in.

The housing market does it

Down the drain

The global growth locomotive, the US economy, fails to recover, as the housing slowdown continues to deepen. Job losses in the construction sector and plummeting home prices feed negatively into consumer and business spending. Despite the recent drop in energy prices, consumer demand drops significantly. A housing-led US slump has become a reality and a hard landing of the US economy is inevitable.

The slump in the US exacerbates the global industrial downturn, and industrial confidence drifts deep into negative territory during Q1.

Even though structural recoveries are unfolding in Japan and Germany, where labour markets and investments are steaming ahead, both countries fail to insulate themselves from the sharp US slowdown. During H1 next year, the global expansion runs off the rails.

At first, central banks are reluctant to accommodate the slowdown, as inflationary pressures initially remain elevated. However, as the slowdown matures, the Fed begins to cut rates late in Q1. Eventually, the ECB follows suit in late Q2, while the Bank of Japan initially remains on hold, with a continued desire to normalise interest rates.

Reactions in asset markets are asymmetric. While the bond market benefits from the slowdown, with even lower yields, it does not react as strongly as the equity market. Equities have been betting on a Goldilocks scenario, resulting in the recent stock market rally, but now take a hard beating. Increasing risk aversion means an even rougher ride for emerging market assets.

As the slowdown matures, labour and product markets slacken gradually and inflationary pressures begin to ease. During 2008, accommodative monetary conditions begin to kick in and the pace of economic growth gradually picks up again. As we enter 2009, the global expansion is back on track, and central banks again begin to normalise interest rates.

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