Global Scenarios: Trends and Risks

• Global business confidence bottoming out
  • while Euroland still has some slowing ahead, the US and Asia will see a gradual recovery in H1
• The US is entering 2007 positioned for stronger growth
  • the construction sector will stabilise, industry is recovering and demand remains solid
• VAT takes shine off German economy
  • but Euroland is heading for a sweet spot
• In Asia, the economies still look strong
  • while the currencies are in the spotlight
• Further monetary policy tightening is on the cards
  • in Europe, Japan and, by late this year, also in the US

Introduction: The expansion that refused to die

• In the US, the jitters in the subprime mortgage market are unlikely to have major macroeconomic ramifications. Contrarily, the turnaround in the housing market will begin to support the economy and the manufacturing sector will strengthen. Hence, growth has bottomed out and is heading for trend. Given continued inflationary pressures this will force the Fed to hike by late 2007.
• European industry, on the other hand, is facing headwinds from the German VAT hike. European industrial indicators should ease - even while the US strengthens. Given the increasingly tight monetary stance, the slowdown in industry should put the ECB on hold after one more hike in June.
• In Asia, we expect further economic strength as US industry picks up. Bank of Japan will be looking an excuse to raise rates again. However, it will be hard to find and we expect only one more hike in 2007.
• Overall, the global economy is not in danger of an imminent slowdown. The problem will, in fact, be too much growth - not too little, as the expansion is unlikely to commit hara-kiri. In the end, central banks will likely have to step harder on the brakes in 2008.

Global expansion is not over

US picks up as housing and manufacturing turn

The present global expansion took off in early 2003. Looking back, the financial markets' perception of this expansion has been jittered with "soft patches", and "slowdowns". The markets appear to have been obsessed with "an imminent end".

And they are at it again. The market currently sees the US economy as being in the midst of a (housing-driven) slowdown that will impel the Fed to start cutting rates soon.

Sure, the case for "an imminent end" is more compelling now than at any previous time in the expansion: US GDP growth did slow in mid-2006, and housing demand has been in a slump since mid-2005. Even so, we think that the bond market is fundamentally wrong about the US expansion.

One main message in this edition of Global Scenarios is that the US is not likely to see growth below trend in 2007. On the contrary, GDP growth looks set to pick up again as early as H1 2007.

The US slowdown in mid-2006 was driven by two inventory corrections - one in the housing market related to the softening of housing demand since mid-2005, and one in US manufacturing, as reflected by the drop in the ISM index from above 56 last summer to below 50 in January this year.

A central call in this issue of Global Scenarios is that both these inventory corrections are almost at an end.

Housing demand has been stabilising in the US since autumn 2006. As we highlighted in "Research USA: US housing bottoming out", from October 2006, this is not as surprising as one might think.

Further, the inventory correction in manufacturing is almost over. US consumer spending picked up in November 2006 as we forecast it would in "Research USA: Housing slows - but consumption might not" (August 2006) and in Global Scenarios, November 2006. The pick-up was not due to warm weather. Neither was it an aberration. It was a reflection of the autumn drop in energy prices that boosted US real incomes and hence spending.

This is not to say that we discount the housing slowdown as irrelevant for US consumers, but housing is not the only important driver for US consumer spending. And with the other spending drivers - energy price trends, the labour market, interest rates and real income growth - remaining supportive, US consumer spending is likely to hold up pretty well, even after the temporary boost from energy prices fades in Q2 2007.

The pick-up in consumption has dramatically improved the inventory/sales balance in US manufacturing (see "USA"). As we highlighted in "Research Global: Business to trough out", February 2007, this implies a rising US ISM index until summer this year (see chart below). The chart also illustrates our track record for forecasting ISM turnarounds.

Fading inventory corrections in US manufacturing and housing imply a boost to US growth in the short run, and we expect growth to return to trend by the summer. Yet again, the US expansion will simply refuse to lie down and die.

This is good news for the rest of the world. While the market has been assuming that the US slowdown would be an isolated event, with the rest of the world continuing to hum along, this was never really likely. As we pointed out in Global Scenarios, November 2006, the market is excessively optimistic on European manufacturing versus US manufacturing. A downward move in European PMI relative to the US ISM is on the cards for H1 2007. Actually, the rise in the ISM in February means it has already begun.

The relative decline of European industry versus US industry will be exacerbated by the effects of the German VAT hike. However, the VAT hike is not the sole or even the main reason Europe will weaken relative to the USA (see "Euroland").

It is important to emphasise that the slowdown in Europe will be a manufacturing slowdown and a VAT-related temporary slowdown in German consumer spending. It is certainly not the end of the European expansion - just as the drop in the US ISM index during the autumn reflected a temporary slowdown in US manufacturing (due to excessive inventory growth) rather than an end to the US expansion.

In fact, the European story has been one of gradual recovery for many years. And this is not likely to end in 2007.

For Asia, the pick-up in the US is also great news. Asian growth still has good momentum - and with the US expansion continuing in 2007, rather easy local economic policies and weak currencies, the Asian boom looks far from over.

In the short term, the worries about the US economy will continue to hang over the market and the central banks. The Fed will stay on hold until the autumn, when we expect a Q4 hike. In Europe, the ECB will go on hold in June, after hiking to 4%. Meanwhile, Japan's central bank will continue to look for an excuse to hike rates. But the BoJ is unlikely to find support for more than one additional hike in 2007. Hence this year will not be one of serious monetary tightening - although, neither will it be one of monetary easing.

For us, the bottom line is pretty simple. It is naïve to think that the global expansion will commit suicide. While central banks have generally eased the pressure on the accelerator, none have really applied the brakes - the expansion will not die before they do so.

USA: Positioning for stronger growth

• The US economy has been struggling on several fronts over the past three quarters, with the slowdowns in the housing sector and industry exerting a significant drag on GDP growth, although strong domestic and foreign demand has prevented a more severe downturn. Further robust demand and generally favourable growth conditions will create the foundation for growth to converge back to trend in H1 2007.
• The US consumer remains the central pillar underpinning our view of relatively robust US growth. And while consumers enjoyed a substantial portion of the positive impact from lower energy prices in Q4, some positive effects remain in Q1, implying another quarter of strong private consumption growth.
• Entering Q2, the energy boost will fade, but sturdy job and wage growth will form a solid backdrop for private consumption. Assuming well-behaved energy prices, real incomes will rise fast enough to absorb slower house price growth and facilitate trend-like consumption growth. The greatest risk to our forecast remains a jump in energy prices or the failure of house prices to stabilise.
• The recent jitters surrounding US sub-prime mortgage market has fuelled fears of a broader US credit meltdown. While the problems in the sup-prime market cannot be ruled out as a risk factor, the risk of a broad credit meltdown is limited. Correspondingly, the sub-prime jitters are likely to have only little macroeconomic ramifications.
• During H2 06 the US faced a double inventory correction - one in housing and one in industry. We expect that the negative impact on growth from these corrections will ease going forward. This has two important implications. First, the ISM index is now off its bottom and US industry is set to pick up in the coming quarters. Second, the slump in residential construction will gradually turn around in H1. In sum, this implies that the current 2.5-percentage-point drag on growth from residential construction and from goods inventories will evaporate in 2007.
• Although core inflation has eased lately, underlying inflationary pressures remain. A tight labour market, strong price pressures from the producer level and generally high capacity utilisation imply that core inflation will move sideways in 2007 at a level above the Fed's implicit comfort zone.
• The Fed has recently become increasingly comfortable with its policy stance, suggesting that the policy rate will remain unchanged throughout H1. However, solid growth and stubbornly high core inflation will force the Fed to retain its tightening bias. Entering H2, the preconditions for a resumption of the hiking cycle will mature, but as we expect the Fed to initially remain cautious, we do not expect any tightening action before late in the year.

Positioning for stronger growth

Double inventory correction

The US economy struggled with a significant slowdown in both the housing and the industrial sectors in H2. Despite the strong momentum in consumer and foreign demand, GDP growth hovered modestly below trend - i.e. between 2- 2.5% - in the last three quarters.

As the chart above shows, the modest level of growth was basically due to the double inventory correction (one in the housing market and one in the industrial sector), which has been countering strong underlying demand. In Q4, residential construction and inventory building alone reduced GDP growth by 2.5 percentage points annualized.

However, as we explain below, the growth mix is expected to become more balanced in the coming quarters, implying growth around trend once more:

1. Housing market will continue to stabilise
2. US industry will turn around in H1
3. Underlying demand will maintain its pace

Housing market stabilising

As we have been arguing since last autumn, a stabilisation in the US construction sector is currently playing out (see Research USA: US housing bottoming out). Recent months have continued to see signs of a stabilisation in housing demand: mortgage applications have risen, the Michigan home buying confidence indicator has improved and the NAHB homebuilder confidence index has rebounded. Although the January report for new home sales showed a sudden dip, the larger picture is still one of a stabilisation in demand for both new and existing homes.

This has two important implications. First, recent data indicate that residential construction spending will stabilise over the next couple of quarters, suggesting that the current 1.2- percentage-point drag on growth from residential construction will likely fade in the coming quarters (see chart below).

Second, a stabilisation in housing demand and a normalisation of inventories of unsold homes will eventually create a bottom for house prices. While some of the high frequency house price indicators have shown falling prices, the broader OFHEO index has continued to print rising home prices, albeit at a slower pace. Going forward, we expect the OFHEO index to show very modest - but still positive - annual house price appreciation.

ISM recovery ahead

The ISM continued to slow during late 06 and into 07. In the coming months, the real surprise - relative to market expectations - is going to be a turnaround in US industry and hence in the ISM. It is crucial to understand that the recent slowdown US manufacturing industry was more related to the energy induced slowdown in consumption spending during H1 than to the slowing housing market. Correspondingly a rebound in the US manufacturing industry is feasible even though the housing sector is still struggling.

Demand for industrial goods has been picking-up over the past six months, primarily due to strong domestic and foreign demand for consumer goods (see chart below). At the same time, inventory building has been slowing. The combo of solid demand for industrial goods and slowing inventories is a strong signal that the ISM has already turned around. (see "Research Global: Business confidence to trough out).

Both our three- and six-month models for the ISM index suggest that US industry is heading for a recovery. In line with our models, we put our ISM target for May at 53. Heading into H2, the index is likely to edge up to around 55, but will probably not move higher from there.

Consumers holding up

While the slowdown in the industrial and housing sector constituted the "dark forces" in the US economy during H2, solid demand from, in particular, the US consumer has prevented a sharper slowdown.

Strong employment and wage growth, the sharp drop in energy prices during the autumn have so far been more than sufficient to counter the negative impact from slowing house price growth.

We expect solid consumption growth of around 4% in Q1 as the remaining positive effects from lower energy prices feed through. Entering Q2, the energy boost will fade - and may actually turn negative for a while if the recent spike in gasoline prices holds - but sustained job and wage growth will form a solid backdrop for private consumption.

Hence, assuming energy prices behave relatively well (in line with our oil price forecast), real incomes will rise fast enough to absorb the negative wealth effect from the slowdown in house price growth and, at the same time, facilitate trendlike consumption growth (see table above).

Note that we are not denying a spillover from slower house price growth, but the slowdown has just not been forceful enough to outweigh the positive factors as slowing house prices work only gradually through the wealth channel. Further, we do not believe that the recent jitters surrounding US sub-prime lending are likely to play any large role from a macroeconomic perspective. The subprime sector represents the lowest quality mortgage segment and constitutes around 15% of the total mortgage market. It seems only natural that some problems should arise in this part of the mortgage market after 425bp of tightening and slowing house price growth. However, we do not rule it out as a risk factor and one should of course, keep an eye on this issue as it could prolong the housing slowdown, but we do not view a credit crunch in the mortgage market as a major risk.

The main risks to our consumption forecast are: 1) home prices failing to stabilise, and 2) another sharp jump in energy prices.

Corporate caution

In contrast to consumer spending, corporate spending stalled in Q4. Lacklustre business spending could very well stem from the slowdowns in industry and the housing market prompting extraordinary caution among businesses.

However, fundamentals for business spending generally remain favourable: financing costs are still relatively low, demand is holding up very well, profit growth remains solid and there are no signs of overinvestment, as business spending is still very low as a share of profits. Moreover, job growth has been robust, which fits badly with the case that corporations are cutting back expenditures permanently. Given the above and our view that industry will rebound and demand growth will remain solid, we expect business spending to regain some traction in H1.

In position for stronger growth

In our view the US economy has been positioning for a growth recovery in recent quarters, cutting housing sector and industrial inventory excesses. Hence, we expect growth around trend in 2007, with risk skewed to the upside in the two middle quarters. This is stronger than the markets and the majority of analysts currently foresee. Heading into 2008, the picture looks benign in the first half. However, depending on the course of Fed policy, which we expect to resume tightening late this year, the growth environment will eventually turn sour. Whether this happens in the second half of 2008 or not until 2009 depends, in part, on how aggressively the Fed moves and how orderly the unwinding of the excess liquidity passes off.

Fed comfortable - for now

Core inflation sideways in an elevated range

Since the Fed paused its tightening cycle last August, core inflation has improved considerably. In Q4 especially, core inflation was remarkably soft, with core CPI/PCE inflation slowing to 1.9%/1.9% q/q AR from 3.0%/2.2% in Q3. That said, the upward trend in core inflation that started late 2003 is still intact.

Going forward, we expect core inflation to move sideways at an uncomfortably high level for the Fed throughout 2007. A still tight labour market, elevated unit labour costs, high price pressures at the producer level and growth around trend imply that core inflation will move sideways at a high level throughout 2007. Interestingly, the composition of inflation sources is likely to change (see chart below).

While housing-related sources (e.g. rent-ofshelter), which were behind much of the acceleration in core inflation in 2006, are expected to ease somewhat later this year, core goods price inflation will rebound. This will largely reflect a feed-through from higher unit labour costs and lagged effects from the run-up in commodity prices last year.

An interesting outcome of this change in composition is that it will put core PCE inflation on slightly rising trend, while core CPI will move sideways. As the Fed tends to prefer core PCE inflation, this could add some concern at the Fed.

Fed to remain sidelined in H1...

Along with slower - but still buoyant - GDP growth, the recent easing in core inflation has been welcomed by the Fed. Generally speaking, macroeconomic developments throughout H2 matched Fed expectations very well. Consequently, the central bank is currently very comfortable with its policy stance (see Flash Comment - USA: A confident Bernanke and Flash Comment - FOMC: A replay of Bernanke's testimony ).

This has left little doubt that the Fed is firmly on hold - at least for H1. That said, the central bank has retained its tightening bias, reflecting its current assessment that inflationary risks remain a larger concern than growth.

...but toughen up in late H2

But where is monetary policy heading in H2? A Fed funds rate at 5.25% means US monetary policy is close to neutral - but not yet tight. However, given our macroeconomic scenario, policy is not yet sufficiently tight to calm inflationary pressures.

The need for further tightening will emerge later in H2. However, the Fed will probably remain relatively cautious, reflecting a desire to be absolutely certain that the housing market is out of the woods before taking any action. Hence, we do not expect any tightening before Q4 this year.

Euroland: In the sweet spot

• Euroland growth slowed from 3.75% annualised in H1 2006 to 2.75% annualised in H2 2006. The slowdown would have been more pronounced had it not been for a stellar performance by Germany. However, Germany's performance is probably due to temporary factors. A substantial portion of the positive surprises last year were due to pre-VAT excess spending and exceptionally strong exports.
• 2007 will see Germany return to its true underlying state, which is certainly healthy, but not extremely strong. For Euroland as a whole, growth is likely to ease only slightly in H1 2007 before stabilising and then accelerating slightly in H2 2007 and into 2008. Two major forces will pull in opposite directions: First, the German VAT bust, which will dominate negatively in H1 2007, and then the re-acceleration in global industry, which will dominate positively in H2 2007 and into 2008.
• The underlying upswing thus still looks fairly solid. We expect investments will continue to rise at a pace a little above trend, although construction is showing some tentative signs of having peaked in some countries. Consumer demand should gain a little strength as consumers enjoy the stable oil price and relatively strong employment growth.
• Next year, 2008, could prove to be a positive surprise after the easing of growth during H1 2007. Indeed, should the global economy continue on a strong footing, there is reason to believe in growth above trend in Euroland after close to trend growth in most of 2007.
• Core inflation excluding taxes may rise a little during 2007, but is set to remain below 2% in both 2007 and 2008. In addition to muted underlying inflationary pressures, favourable base effects will push headline inflation significantly below 2% over the coming quarters so long as the oil price remains stable. With contained inflation and solid growth, Euroland will be in the sweet spot.
• The ECB is still pushing for a normalisation of monetary policy to 4.0%, which we expect will be reached by June. For the remainder of the year and into 2008 the overall economy is likely to be consistent with the ECB on the verge of further policy tightening, as falling unemployment will keep the ECB on guard.

Germany facing reality tests

The Value Added Test

The strong performance of the German economy in 2006 looks less impressive now than it did just three months ago. In our view, the ifo skyrocket was partly due to two temporary factors:

1. The Value Added Tax hike in January 2007, which we believe boosted German growth throughout all of 2006, not just the final few months
2. Exceptionally strong German exports in H2 2006 when the global economy was actually gearing down a notch, and when incoming export orders looked significantly less strong

In "Research Germany: VAT rollercoaster", from 30 October 2006, we argued that the VAT hike would likely create a boom-bust scenario in the German economy, as consumers would bring forward demand to the final months of 2006 and then remain sidelined in the early part of 2007.

This seems to have indeed been the case. In the chart below we show German retail sales along with our forecast from 30 October. The actual boom-bust development has been stronger than the historical pattern suggested.

The VAT hike may also have generated powerful dynamics earlier in 2006, inflating consumer and business confidence to levels not warranted by the underlying strength of the economy.

Consumer strength has been reflected in various surveys where consumers are asked about their willingness to make "Major purchases at present" (see chart below). The "Major purchases" subindex took off right from the moment the VAT hike was announced in the autumn of 2005, and probably contributed to the strength in the ifo index throughout all of 2006.

Hence, it is worth noting that the part of the ifo index which surprised most positively during 2006, namely "current conditions", historically correlates well with the "major purchases" subindex. In fact, if one estimates ifo current conditions on historical data, "major purchases" usually turns out to be very important in explaining Ifo current conditions (see chart above). This suggests that ifo current conditions has indeed been inflated long before the VAT hike. According to our estimates, the VAT bust, as reflected by the weakening of willingness to buy, is likely to dampen ifo current conditions by some 10 points over the coming 6-9 months, bringing it down to normal historical highs (see chart below).

Thus, the VAT effect should not be underestimated - it is one reason why Germany will not look as miraculously strong by the end of 2007 as it does right now.

The test for the German locomotive: Can it run on other fuel than exports?

Another reason why Germany is likely to descend from the clouds in 2007 is that the exceptionally strong momentum in exports in H2 2006 is unlikely to be repeated. Germany was probably the top performing OECD nation in terms of exports in Q3 and Q4 - German exports rose more than 20% (annualised) over the period on the back of very strong exports to emerging markets.

Given this strong export performance, it is much less surprising that the German economy maintained most of its momentum in H2 2006 in the face of slowing elsewhere. In fact, one could say that the primary fuel in the German locomotive is still exports and not domestic demand. Net exports contributed some 3 percentage points to GDP growth y/y in Q4, whereas private domestic final demand (fixed gross capital formation and consumer demand) only contributed 1.5 percentage points to growth (see chart below).

But looking forward, it is worth noting that incoming export orders have moderated significantly since Q3. This is important, as orders usually lead actual exports by some 2-3 months. Furthermore, export orders usually lead the ifo expectations index as well (see chart below).

Thus, summing up, most of the miracle glow surrounding the German economy will fade during 2007, with a more realistic picture of the German economy emerging as a result.

Domestic investment recovery intact

While temporary factors have boosted the German economy, there is little doubt that the underlying expansion remains fairly strong. The investment recovery that started in mid-2005 has been broadly based, encompassing both equipment and construction investment. Economies outside Germany look less impressive. France, especially, is still struggling to get its exports going.

Given the strong exports earlier, the high capacity utilisation and assuming solid earnings continue, we believe the investment recovery will remain in place. However, there are some tentative signs that the construction sector has peaked in some euro countries (see chart below) - if so, a significant driver of the economic expansion will disappear. On balance though, we believe the construction sector is set for just a moderate correction.

Private consumer demand looks solid, although, slightly surprisingly, still not strong. In 2007 and 2008 we are looking for consumer demand to grow just above trend as the lower oil price and continuing strength in the labour market lend support to real incomes.

Muddy picture for the ECB

Labour strength will not harm price stability Labour markets have shown unusual strength in this recovery. Despite four years of GDP growth below trend between 2002 and 2005, employment actually rose - and rose further in 2006. The result has been easing unemployment, which peaked in May 2004 at 8.9% and has since fallen to 7.4%, which is probably around the structural unemployment level.

However, it is worth noticing that the Phillips curve (unemployment and wage growth inversely correlated) has essentially broken down over the past ten years, as can be seen in the chart below. While unemployment has vacillated, real wage growth has remained surprisingly stable.

However, the chart also reveals that the expected negotiated real wage over the past ten years has been stable. In other words, consumers demand wage rises according to their perception of inflation without paying much attention to the state of the labour market. Given the run-up in consumer inflation expectations over the past year, there should be a moderate pick-up in wage growth over the coming year (see chart below).

Still, given the historically low rate of wage growth, we believe wage growth could rise moderately without endangering the ECB's inflation target. In fact, incorporating a rise in wage growth from 2% to 2.75% over the coming year leaves our model on Euroland core inflation (excl. taxes) indicating a less than 2% outcome for both 2007 and 2008. This remains the case even as other second-round effects from the higher oil price continue to feed through into inflation.

While core inflation is unlikely to go above 2%, it will probably climb a little during 2007 and maintain pressure on the ECB to raise interest rates further.

It is worth noting that given the stabilisation of the oil price, ECB and consensus inflation forecasts have been revised down to below 2% for the first time in many years in Euroland. Thus, further hikes from the ECB are not a sure thing.

ECB aiming for 4%

We have several times argued that the ECB was aiming for a 4% policy rate. Still, we have been a little surprised by the speed of the policy adjustment. Since the previous issue of Global Scenarios we have adjusted our forecast for the ECB, having it reach 4.0% by June before going on hold. Earlier we expected the ECB to raise rates later in 2007.

The outlook for the ECB beyond the 4.0% it will reach in June is rather blurry. On the one hand, the ECB is looking at a situation, where growth is likely to hover close to trend, inflation should be on target and the policy rate neutral. On the other hand, unemployment is still falling rapidly, credit growth is still strong, and the inflation outlook is still subject to some upward risks. In our scenario, the ECB will remain on hold after the June hike for some time. However, we do not consider 4.0% to be the peak in this expansion. We are likely to see more tightening from the ECB by mid- 2008, or possibly, and there is a risk that the ECB may not pause at all, but continue to hike in this autumn.

Asia: Yen and yuan in the spotlight

• Over the past weeks Japan has caught everyone's attention in the global financial marketplace - not so much because of its economy but due to its currency. Is there a fundamental argument behind yen strength?
• Japan's industry looks set to point upwards as spring turns to summer. This will underline continued strong corporate spending. However, the Japanese labour market may not yet be tight enough to create significant wage pressure. Hence, we may face another bumpy year for Japanese private consumption despite the corporate boom.
• Despite its forward looking approach to monetary policy, the BoJ will likely want to see an uptrend in inflation before raising rates. With core CPI only a bit above 0% on a yearly basis we believe it will be difficult for the BoJ to raise rates before H2 2007. Therefore, with carry trade still a core theme in the currency markets we still expect the yen to weaken during 2007, despite its clear undervaluation.
• We expect that China's industry will start to creep upwards during spring. A pick-up in China's industry should also support investment growth staying at close to 20% y/y throughout 2007. As a result, we forecast that China will continue to grow at a speed close to 10% in 2007.
• In 2007 the Chinese authorities will form a profit-oriented investment agency which will manage part of the FX reserves. Moreover, the Chinese authorities will allow for more flexibility in the renminbi against the dollar - probably by a widening of the currency band.

The fundamental argument for yen strength

After the storm

Over the last weeks, the yen has strengthened forcefully, which has created fear in financial markets that an unwinding of the so-called yen carry-trade is under way (see our commentary Research - Emerging Markets Briefer: It ain't over till the fat lady sings, March 1 and FX Strategy: From carry to valuation, March 5). In the midst of the storm, one should take a close look at the Japanese economy: is there a fundamental argument behind yen strength going forward?

Strong corporate Japan

The financial stimulus coming from the weak yen, easy monetary policy and the shift from asset deflation to asset inflation continue to provide strong support for Japanese companies. During H2 06, Japan's industry boomed despite the slowing US (and Chinese) industry. The drivers were reasonably strong export growth but also a build up of inventories. Inventory dynamics suggest that industrial production will soften in the coming months (see Research - Global: Business confidence to trough out, February 28). However, with the US industry bottoming out and with the financial stimulus still in place, Japan's industrial trend looks set to point upwards as spring turns to summer. This will underpin continued strong corporate spending, which is still very much driven by Japan's export/industrial production cycle.

Waiting for the consumer

So much for corporate Japan - what about the other side of the economy? The story throughout 2006 was that the strong performance in the corporate sector did not significantly spill over to the household sector. Private consumption stalled in Q3, although it rebounded in Q4. Throughout this recovery there has not been any clear uptrend in private consumption, which continues to be flat and bumpy.

The crucial question is why this is the case and whether it is something that will change during 2007? We believe the most important reason for weak consumption growth is subdued wage growth. Monthly wage indicators have been flat over the past few years. Although, we do not find the same relationship between real wages and private consumption in Japan, as in the US for example, sluggish wage growth is clearly one strong reason behind relatively weak consumption growth in Japan.

The Japanese labour market has tightened significantly. But as we have already argued, it may not yet be tight enough to create significant wage pressure. As the corporate expansion continues, we expect the Japanese labour market to tighten further in 2007. But the unemployment rate may have to fall below 3.5% before wage pressures kick in. This will still take some time. Hence, we may face another bumpy year for Japanese private consumption despite the corporate boom. However, we think that huge drops like those seen in Q3 06 may be a thing of the past as this may have partly been triggered by the very strong rise in energy prices through Q2 and Q3. Hence private consumption is likely to be more stable in 2007..

Inflation in the spotlight

As a result, the attention of the Bank of Japan (BoJ) is likely to shift from private consumption to inflation. Due to base effect and lower energy prices, core CPI is likely to stay close to 0 on a yearly basis in the coming months. In line with its forward-looking approach to monetary policy, BoJ will look into the basic mechanism behind inflationary pressures in Japan. In our view, the tightness of the labour market, continued strong economic growth and the weak yen are the cornerstones behind slight inflationary pressures in Japan. We expect core CPI to edge towards 0.5% in 2007. Despite its forward looking approach to monetary policy, the BoJ will likely want to see an uptrend in inflation before raising rates. With core CPI only a bit above 0% on a yearly basis we believe it will be difficult for the BoJ to raise rates before H2 2007.

The yen rally - was that it?

Where does this leave us in terms of the yen? We still expect the yen to weaken during 2007, despite its clear undervaluation especially against the Euro. Our view is based on two premises: (1) Carry trade will continue to be a focus in the G10 currency markets in 2007 and (2) The BoJ will move too slowly to significantly narrow the interest rate differential between the US and Euroland. However, the last weeks have shown us how fast things can change if everyone needs to exit the same door at the same time. There is clearly a risk that the yen will strengthen by say 20% versus the Euro during 2007. The key risks are the state of the US/global economy and the BoJ. Firstly, if investors get nervous that the US/global economies are not in such good shape they will pull money out of risky assets to the benefit of funding currencies such as the yen (see Alternative Scenario 2 below). Secondly, if we get indications that the BoJ is starting to tighten monetary policy at a faster pace, e.g. every three to four months, we may get a fundamental re-pricing of the yen.

From growth to FX reforms

What about the rising giant, China? The Chinese economy has been slowing over the last half-year, although the economy is still growing at a very fast pace. The triggers have been (1) the tightening campaign introduced by the Chinese authorities since last spring and (2) the slowing global industry. The feeling from our recent trip to China is that the Chinese authorities will maintain their tightening stance in 2007 (see Research China - Booming growth and big FX reforms - but challenges loom, March 1). However, with investment growth already down to 20% y/y, the Chinese authorities should be relatively comfortable about the current state of the economy. M2 growth has come down from its peak and bank-loan growth is close to the PBoC's target of 13% y/y this year. Hence, we do not expect much more tightening of money/credit policy. And with the US industry likely to have bottomed out, our stimulus indicator indicates that China's industry will start to creep upwards during spring. A pick-up in China's industry should also support investment growth staying at close to 20% y/y throughout 2007. As a result, we forecast that China will continue to grow at a speed close to 10% in 2007.

Turning to financial issues, we expect that FX reforms will be a big story from China in 2007. The Chinese authorities have confirmed that they will form a profit-oriented investment agency which will manage part of the FX reserves. The agency will probably invest in bonds, stocks and probably energy supplies, which will mark a big change relative to the current management of FX reserves where the focus is on highly liquid government bonds. In our view, the change on the margin will be dollar negative, positive for risky assets such as equities and emerging market bonds, and negative for developed market bonds, see the report (see Research China - Booming growth and big FX reforms - but challenges loom, March 1) for a thorough description and the likely implications.

More flexibility in the pipeline

What about the Chinese currency itself? The Chinese authorities have, since August 2006, allowed for a faster appreciation of the renminbi versus the US dollar - around 5% on an annualised basis. We expect this process to continue. What has been surprising, however, is that the authorities have not allowed for more flexibility. If the ultimate goal of currency reforms is to move towards an independent monetary policy, the authorities should move away from a crawling dollar peg and towards a crawling currency basket. We expect that the Chinese authorities will move down that road during 2007.

Alternative 1: Mr Phillips wakes up

• Underlying inflation has been unusually subdued in this expansion. However, robust growth means labour markets continue to strengthen in all regions of the world. So far, lower unemployment has not given rise to much wage inflation. However, the inverse relationship between unemployment and wages postulated by Mr A. W. Phillips (the so-called Philips curve) is likely to re-appear in 2007.
• Conditions in labour and product markets fail to ease as US growth recovers and the structural recovery in Germany and Japan continues. This leads to a further acceleration in inflation and a self-propelling increase in inflation expectations. Global central bankers find themselves in a behind-the-curve scenario, prompting an urgent need to tighten monetary policy.
• Central banks have to 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, with emerging markets being hit especially hard, since they have benefited the most from awash-with-cash conditions. Housing markets slump again, with global housing prices dropping 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.

Wages do depend on unemployment

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 missed or at least failed to respond adequately to the early warning signals from global product and labour markets, and they find themselves in a behindthe- 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 growth still close to, or even above, trend, an urgent need for 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 assets market are significant, and the first signs of a deeper and more prolonged correction emerge during the spring.

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

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

Global economic growth remains subdued for a considerable period of time, as central banks do not 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 a recovery mature in early 2009.

Alternative 2: Financial risks turn real

• The sharp risk withdrawal recently proves to be an important warning signal of what is in the pipeline. The correction in the US housing market continues and is starting to have a strong, negative effect on US private consumption. The weakness in US private consumption spreads to Euroland and Asia, and so the global economy slows down significantly.
• As a result, risk reduction comes out as a core theme in 2007. Volatility in financial markets takes hold at a permanently higher level, and risky assets come under pressure. The most vulnerable are the ones where market positions look most stretched: carry trades in the currency markets, low-quality corporate and emerging market bonds and high-beta equity markets.
• The sharp correction in financial markets sends shock waves back to the real economy. A credit crunch develops in the US mortgage market, and the widening of emerging market and corporate bond spreads puts pressure on credit conditions on a broader scale. Moreover, some financial institutions come under pressure.
• Global economic growth slows further as tighter credit conditions and the deepening financial distress weaken investment. A negative spiral between the real economy and the functioning of financial markets develops. As a result, global central banks besides the Fed start to ease monetary policy in 2008. Ultimately, the global economy recovers, although the strong global expansion has come to an end.

A negative spiral develops

Risk reduction here to stay

The recent sharp reduction of risks in global financial markets proves to be a warning signal of what is in the pipeline. The trigger turns out to be increased uncertainty about the condition of the US economy. The positive effect on Q4-Q1 US private consumption of falling energy prices in the autumn fades and the housing market correction continues. This begins to have a strong, negative wealth effect, and US private consumption comes out on the sluggish side in Q2- Q3. The drop in US private consumption puts pressure on US industry, and the ISM indicator drops significantly below 50. Weak economic indicators and subdued inflationary pressures force the Fed to cut interest rates in the autumn of 2007.

The significant slowdown in the US economy spreads to Europe and Asia through the channels of global industry and foreign trade. European industry is feeling the pressure both from the German VAT increase and the drop in US industry. Weak demand from the US hurts European and Asian exports. Hence, the strong driver of export orders for the German economy falls apart and growth softens. Asia is unable to de-couple from the US, and Asian growth slows as demand from the US and Euroland softens.

In response, the financial markets cut risk taking significantly. Investors realise that volatility has simply fallen too much relative to the fundamental condition of the global economy, and volatility moves to a permanently higher level. This causes a fundamental re-pricing of risks in global financial markets, which puts risky assets under pressure. The assets that turn out most vulnerable are the ones where market positions look most stretched, i.e. carry trades in the currency markets, low-quality corporate and emerging market bonds and high-beta equity markets. Conversely, high-quality developed market bonds rally on lower US monetary policy rates and safe-haven flows out of risky assets.

The sharp correction in financial markets sends shock waves back to the real economy. The weakening in the US housing market spreads to credit markets, and a credit crunch develops in the US mortgage market. Also, the widening of corporate and emerging market bond spreads puts EM and corporate credit conditions under pressure. The significant increase in volatility puts pressure on financial institutions, which have taken strong bets on still low global volatility. Especially, some mortgage lenders and global hedge funds come under pressure.

Global economic growth slows further as tighter credit conditions and the deepening financial distress weaken investment. A negative spiral between the real economy and the functioning of financial markets develops. As a result, global central banks besides the Fed start to ease monetary policy in 2008. In the second half of 2008, the global economy recovers, although the strong economic expansion has come to an end for now.

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