Mid-Year Review - 2008: Inflation Steals the Picture

In March the economic world was facing two major challenges: 1/ The financial crisis and 2/ Prospects of a significant slowdown in growth (recession). The good news is that the financial crisis does not seem so searing after the Fed drew a line in March and guaranteed the existence of the banking system. The bad news is that rising inflation has emerged as a third challenge.

The financial crisis has receded into the background, and the banks attempt to regain confidence in each other and have sought new capital to patch the 'holes'. But it is too early to declare that the crisis is over, so investors must still take it into account.

Global growth seems to slow after surprisingly strong growth in the first quarter of 2008. However, slow growth has not been cancelled but rather delayed. Therefore, we still expect a recession in the US.

But a new and unwelcome visitor has announced its entry. Inflation is a growing problem for the world economy. Global consumer prices rose by 4% in April - a nineyear high. EM inflation has increased even more dramatically by more than 3 percentage points since early 2007 to 7.6% The main reason is rising oil and food prices (see the section about commodities), and the central banks fear that the price increases will spread to other areas and lead to higher wage increases.

As an investor there must be focus on several themes. 1/Equities and high-yield bonds have increased significantly since mid-March, but we do not expect that it will be a lasting increase since the fundamental situation still implies many challenges. By many the movement is called a bear market rally (increases in an otherwise sluggish market).

2/ The rotation of slow growth from the US to Europe and Japan. We already have an underweight recommendation for European equities and an overweight recommendation for the US. Conversely, European government bonds hold a higher potential than American government bonds. Also, stick to the view that USD will strengthen against EUR.

3/ Given the indications that more poor economic indicators will be released following a surprisingly strong quarter and a period of significant increases in risky assets, it is not the time right now to increase the risk. In fact we cannot rule out that long-term yields will fall again after the sharp increase since March. To this should be added that we lower our return estimates for the equity market a bit for the rest of the year (following a solid profit since mid-March).

4/ The opportunity/risk of a fall in oil prices in the course of the second/third quarter. Therefore, there is reason to be cautious as an investor in the commodity market, although we expect the oil price to stay above US 100 in the long term.

Looking ahead towards 2009, when the growth pause is expected to be over, and commodities have overcome a possible short-term correction, inflation can become a serious problem for the financial markets. We'll cross that bridge when we get there.

USA

Signaler from the economy show that the huge American cars have changed into a low gear and are about to reverse. I.e. we still expect that the economy slips into recession. However, the speed has been a bit faster than predicted in March. However, there are still major challenges ahead in coming months, which will be reflected in weaker economic indicators. Inflation has become an issue due to significantly rising oil and food prices, which may explain why the central bank has gone on 'summer holiday'.

In the first quarter, GDP rose by merely 0.6% for the second time on end, and the growth rates for these two quarters are the slowest since the recession in 2001. Consumers in particular have caused the slower growth rate. They postpone purchases of durable consumer goods such as cars and put fewer goods in the daily shopping basket.

In our view, consumers hold the key to growth in coming quarters. They are under pressure from rising prices for energy and food, falling employment, higher unemployment, falling house prices and in addition it has become increasingly difficult to take up bank loans. They are, however, supported by tax cheques worth of slightly more than USD 100m, which may lift consumer spending in coming months, and by the Fed's interest-rate cuts. Overall, we expect that consumer spending will remain very moderate, but that it will improve in the second half of the year compared with the first six months.

Generally, there are indications of stronger growth in the last six months of the year than in the first six months, but the level is still very low. Growth in the last six months will be supported by solid growth in exports and beginning stabilisation in housing construction (has pulled down growth by approx. 1 percentage point in the past eight quarters). Companies are expected to reduce investments up to and including the third quarter, while the prospects are slightly better for the fourth quarter.

The fear of rising inflation has become a big issue in the wake of rising prices for oil and food and the weak dollar. This has caused consumer prices to increase by 4% over the past 12 months. Rising consumer prices are mainly caused by external factors, while the domestic inflationary pressure is likely to fall. Thus wage increases have declined by 1 percentage point to 3.4% and productivity growth remains solid.

There are indications that the Fed leaves interest rates unchanged in coming months. Slow growth points to further cuts, but the fear of rising inflation, the calmer financial markets and the effect from the interest-rate cuts carried out so far mean that the Fed has interrupted its rate-cut cycle. However, we expect it to be resumed later in the year.

Euro zone

The euro zone has enjoyed solid growth at the beginning of the year. Notably strong growth in Germany has contributed to a picture of a resistant European economy. This is, however, not a general picture of the economic development in the euro zone. Economic indicators signalling the future development, new orders and business tendency surveys point to slower growth both in Germany and in the euro zone in coming quarters.

Exports are about to be squeezed by slower global growth. And the competitiveness is squeezed by the strong euro and a poorer development in productivity. Investment growth has been solid for a long time, but as capacity utilisation has started to fall, and the growth prospects have grown bleaker, we expect investment growth to fall.

Consumer spending is the third wheel of the growth engine. For a long time, it has showed a disappointing development. Given an inflation rate which is currently somewhat above the increase in wages the purchasing power of the households is drained, and we expect disappointing growth in consumer spending for 2008. Some improvement is expected next year as the development in real wages improves. However, there is a risk of yet another weak year for consumer spending, if increased economic uncertainty will cause a surge in the savings ratio.

We assess that euro zone growth will land at 1.5% for 2008 and 1.6% next year. This is a marginal increase for 2008 and a slightly larger fall for 2009. But for both years growth will be below the potential growth rate, and we therefore expect that unemployment will start to increase, and the general pressure on the resources of the economy will decline. Not least the pressure on wages and inflation. This is a key point, if the ECB must take action and support growth by means of interest-rate cuts.

We expect that the ECB lowers interest rates by a quarter point in the last quarter of 2008 and by another quarter point in the first quarter of 2009. This is one quarter later than our original estimate. The main reason for this change is that inflation has surprised to the upside and that we do not expect inflation to approach 2% until in 2009.

We also assess that uncertainty about our interest-rate forecast has increased as a result of the high inflation rate. The development of inflation is of vital importance for our expectations as to the ECB's behaviour. And it is also important that the inflation expectations do not surge all of a sudden. This is an element of danger that cannot be ruled out given the prospects that inflation remains high throughout 2008. This is also the main cause for concern at the ECB and in reality not the fact that inflation is temporary high due to high energy and food prices.

Japan

The Japanese economy is slowing down. The export sector, which has maintained momentum, is about to be hit by the global slowdown in growth, and there are no indications that the domestic economy will takeover the role as growth engine. Consumer spending is under pressure due to falling real wages and lower employment growth, and the weaker export prospects adversely impact on investments, just as the companies' profits are squeezed by high commodity prices.

We assess that slower growth will materialise in the two middle quarters. In the second quarter, growth will be in the red as a reaction to surprisingly strong growth in the first quarter. For 2008 as a whole, we expect a growth rate of 1.3%, which is marginally below the potential growth rate. The risks to the growth forecast are mainly on the downside.

Also in Japan rising food and energy prices have led to rising inflation. The rise in consumer prices has climbed above 1% y/y, which is the highest level since 1998. Core inflation (exclusive of food and energy) remains around zero and given the prospects of a slowdown in growth, there are no indications that inflation is generally on the increase. Although rising inflation is cause for concern in the short term, it may in the longer term be an indication that the Japanese economy is stabilising. It has for long been hit by deflation.

We expect that the Bank of Japan leaves interest rates unchanged at 0.5% for the rest of the year. An interest-rate hike is not expected until mid-2009, when growth has picked up again, or when core inflation begins to show signs of a clearly positive trend.

China

Following some years of rising growth the pace of economic growth is about to slow down in 2008 and 2009. In 2007, economic growth peaked at 11.9% - the sharpest growth rate in 13 years - and we anticipate that economic growth will slow down to just below 10% this year and to around 8%-9% next year. Slower growth will be a result of slower global growth, a stronger currency and the initiatives which the central bank has taken and will continue to take to curb lending growth and control inflation.

Inflation has surged since early 2007 and in February 2008 it peaked at 8.7% y/y (8.5% for April), i.e. the highest inflation rate in almost 12 years. The high inflation rate is driven by food prices - exclusive of food prices inflation is below 2%.

As opposed to in most other countries, crops are not driving up inflation, since the main part of the crop price is controlled by the government. Meat prices, on the other hand, have contributed with more the 85% of the increase in inflation, above all due to an illness among pigs, and a heavy snowstorm in January/February also led to rising prices for vegetables. We expect inflation to fall significantly later in the year as pork prices start to normalise and the effects of the snowstorm abate. However, there is a risk of sustained high inflation which will hit the consumers and pull down growth. Therefore, it is important for the central bank and the government to attempt to dampen the inflation expectations. So far, the central bank has raised the banks' reserve requirement by a total of 2 percentage points in 2008 (7.5 percentage points since early 2007) to 16.5% and it will undoubtedly raise the reserve requirement further this year.

Energy prices are also among the products which are controlled by means of subsidies in China. Therefore, the sharp rise in global oil prices has not had any significant spill-over effect in China. Artificially low energy prices keep up demand and thus also contribute to keeping up the global oil price. In 2007, China accounted for about 30% of the world's total growth in oil demand.

Money market

Both short- and long-term rates have risen. Interest rates reached a low in mid-March. Notably short-term interest rates were affected by the fact that the markets no longer expect further interest-rate cuts by the central banks, rather the opposite. The rise in long-term interest rates is a consequence of the markets' increasing focus on inflation.

The markets have for a while relegated the fear of renewed turmoil to the background. This may turn out to be too soon and too optimistic. For the short term, there may easily come new information pointing to slower growth. Conditions in the American and European money markets have still not normalised. There are still high risk premiums for risky transactions. Lately, the situation in the American market has become less tense while short-term European rates have still not shown signs of improvement. The central banks' injection of new liquidity has thus not yet had any major effect. This is disappointing, but the reason is probably that the confidence among financial actors has not yet been restored.

Forecast: first falling then rising rates

With respect to the current market sentiment, we expect a counter reaction. Uncertainty about the true condition of the economies may prompt interest rates to fall again, but not all the way to the low levels in March. The movement will be accompanied by expectations of falling central-bank rates in both the US and Europe. When the financial turmoil calms down later in 2008, long-term rates will rise. Expectations that central-bank rates have already bottomed out and of low real interest rates as well as the fear of inflation will push up long-term market rates later in 2008.

We expect the 10-year rate to be between 4.00% and 5.25% at the end of the year, i.e. that the mean estimate is 4.63% against currently 3.86%. In Europe, we also expect market rates to rise but at a much slower pace. Our mean estimate for the euro zone and Denmark is 4.50% and 4.70%, respectively. This means that we expect American rates to exceed euro zone rates during the last six months of the year!

FX market

So far we have been looking for the expected dollar appreciation in 2008 in vain. In fact, the dollar reached a new historical low at 160.20 (EUR/USD). The difference between the monetary policy pursued in the US and the euro zone has simply been too big to leave sufficient scope for the troubled dollar to recover.

Nevertheless, we maintain our bullish view of the dollar due to our expectations of low ECB rates and not least the financial conditions for the dollar which appear to be slowly changing. The market sentiment in terms of speculative IMM investors shows that a change of sentiment in favour of the dollar may very well be in the making. The financially hard-pressed American investors are apparently repatriating their foreign investments. We have waited a long time for notably this repatriation to support our bullish dollar view.

After having fought against the wind turbines in the FX market in the first six months, we tone down our bullish view of the dollar. At 3- months' term we now expect an encounter with 148 and at the end of the year we expect a dollar rate around 137. Thus, we maintain our original expectation of a trend change for the dollar, only the pace is more moderate.

In a general economic scenario where we still expect poor economic indicators, we predict that the volatility will generally rise in the FX market which will again force the popular funding currencies on the defensive. We therefore recommend investors to have a defensive funding portfolio also for the last six months to tone down the risk.

Sterling is still on a retreat due to the rough economic and financial winds blowing over the UK. We therefore maintain our expectations of sterling below the magic DKK 9 at the end of the year. SEK, NOK and the three commodity currencies also look set to be in for a beating if volatility rises in earnest as expected. If that happens, risk aversion will surface with a flash and a clap of thunder.

Commodities market

The oil price continues to increase unabated in spite of slower economic growth in large parts of the developed world.

On that background, we revise up our expectations of the oil price in 2008 to an average price of USD 113 a barrel. A continued weak dollar, disappointing supply growth, continued robust demand growth and inflow of speculative funds are the main reasons behind the upward revisions. However, we maintain our expectation of a price correction during the second/third quarter as the economic indicators deteriorate and in view of the prospects of a markedly stronger dollar which is expected to push more speculative investors out of the market. We assess that the risk for our estimate is mainly to the upside.

For the slightly longer term, we maintain an oil price above USD 100 a barrel, cf. the analysis 'Are high oil prices here to stay?'. The reasons are strong demand growth in emerging-market countries, rising production costs and limited access to production capacity as well as the need for further production capacity.

The oil market is now in an investment phase where prices must be sufficiently high to motivate investment in production capacity for both refining and extraction of crude oil. In other words, the price of oil not only reflects rising costs but also technological risks of untested equipment, geopolitical risks, long repayment periods and the like. As opposed to previously, supply growth will come from nonconventional fields, in which extraction costs are higher and the technological challenges greater. For 2009, we expect the average oil price to trade at USD 115 a barrel.

Like the oil market, the metal markets are characterised by large structural problems and sharp inflation in production costs. Both copper and aluminium prices are as expected just below the record levels at USD 8880 and USD 3300 a tonne, respectively. We maintain our expectations of the two base metals for the third and fourth quarter, which means that we expect a minor price correction at 0 - 3 months' term while the expected level at the end of the year is maintained although with a minor risk to the upside.

With respect to crops, we expect that the wheat price is about to bottom out, which means slightly rising prices from the current levels for the rest of the year. Furthermore, we maintain our expectations of corn and soy beans.

Equity market

Our thesis for 2008 was that the second quarter would significantly outperform the first quarter and that the last six months would significantly outperform the first six months.

This thesis will be slightly changed. We have already seen part of the rises which we had expected in the third quarter. The second quarter was thus somewhat better than expected.

At the same time, energy prices have risen dramatically, which prompts us to lower our expectations of the full year. But not dramatically.

True, accounts - outside the financial sector - have generally been better than expected/feared and true American consumers are stimulated in these weeks. But at the same time, consumers are in for a heavy beating. Not only through falling property prices and tightening of credit standards but also through the sky-high energy costs.

As a natural consequence of a somewhat better than expected second quarter - we revise down our estimate for the last six months moderately. The thesis is that either energy prices will fall - even quite a bit - or the effect of the rising energy prices will be a worthy opponent for equity investors in the remaining part of 2008.

The message is not that equity prices will fall dramatically. However, the challenges are so considerable that even a continued sensible valuation is not sufficient to ensure massive rises in the last six months.

Emerging markets

Looking back at the performance so far in 2008 in the emerging markets, we can identify three periods.

After the credit crisis had a major impact on the asset class in the first quarter, there was a decisive change in the market sentiment over Easter since the markets' fear of systemic risks in the banking sector was put to rest following the takeover of Bear Stearns, a string of initiatives from the authorities, a 75 bp cut by the Fed and a few better-than-expected banking accounts.

In April, the financial markets breathed a sigh of relief, and the emerging markets followed other risky assets on their way up. In May, there was no real direction, and the emerging markets traded sideways. These three periods are illustrated by the return on a carry basket of emerging-market currencies (long ZAR, TRY and ISK against EUR) which is often a good sentiment indicator of the emerging markets.

Despite the encouraging performance in April, we found it necessary to tone down the optimism for the rest of 2008.

Although we believe that the worst part of the credit crisis was over in March, we have not yet seen the fallout of this crisis. The markets will still have to get used to slower growth ahead, especially in the US but also in the rest of the world. Moreover, fundamentals in some emerging-market countries have deteriorated as slower growth goes hand in hand with rising inflation (see 'EM inflation - an unwelcome visitor', May 2008). The result is a tightening of the monetary policy (for instance in South Africa, Turkey, Hungary, etc.).

However, it has the opposite effect that the emerging markets still account for the majority of global growth although growth is slowing but the slowdown is from a sensible level. Due to the above, we expect a return for the year as a whole around 5% (in local currencies). The main risk behind this estimate appears to be the rising commodity and notably oil prices. While rising commodity prices may not necessarily have an adverse effect on the emerging markets (where commodities generally account for a large proportion of their exports), growth and inflation in the emerging markets (notably in Central and Easter Europe) are affected, also indirectly by the effect of the global growth expectations and the sentiment in the global markets.

Corporate-bond market

At the end of the first six months, the global default rate will be about 2%. For the long term, it is still this rate which is most important for the sentiment in the credit market. The latest reports from the Federal Reserve and the ECB indicate that lending standards have been tightened in the financial system. The ratio of downgrades to upgrades is also rising at the moment. This is usually a good indicator of whether the default rate will rise. We expect the default rate to rise to up to 5% at the end of the year and probably further in the first six months of 2009.

The market is currently discounting a default rate slightly above 5%. When things were at their worst, the market expected a default rate of about 6.5%-7%. The pace with which the default rate rises is very much a function of lending conditions. In our view, it is therefore positive that in spite of much trouble the financial system has so far been able to raise capital.

Moreover, government bodies have shown their support of the system. But so far the capital injected has not resulted in improved lending conditions for weak borrowers. Whether consumers or businesses. For the High Yield segment, this means that businesses will have to focus on profitability, keeping a low profile and alternative funding sources.

From late 2005 until mid-2007, there were many new issues with a leverage ratio in the 6- 9x range. It appears as if this group will run into problems in late 2008 and not least in 2009. Hopefully, businesses realise that times are different. Banks and other creditors (investors in credit) squeeze businesses to take the right step which is a difficult process since the shareholders (almost) always have a front seat.

We expect the market to move sideways (although with large swings) and that Xover will end at around 450 which is an adjustment of our previous estimate by 25 bp, up from 425 bp.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt

The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice. The analysis is for personal use of Jyske Bank's customers and may not be copied.