Strategic Outlook: Recession on the Tapis
Following recent economic indicators, we are convinced. Our main scenario now points to recession in the US.
This year economic growth will be just above 1% (from 2.2%) and in 2009 economic growth is expected to be about 2.5%. Weaker growth in the US will also lead to weaker growth in the rest of the world. Economic growth in the euro zone is expected to be at 1.4% in 2008, while in 2009 the rate will be at 1.9%.
Economic growth in the emerging markets will also be affected, yet presumably to a lesser degree than during previous recessions as several countries now have become net creditors and they have become more flexible with respect to easing their fiscal policy.
We still expect that the growth scenario will be better in H2 even though the level of economic growth will now be considerably lower. Therefore, the main scenario is that we will see a fairly short-lived recession, but as the weakest growth impulses will be within personal spending in the US, there is some risk that it may drag out. However, tax cuts and pronounced interest-rate cuts will lead to increasingly moderate economic growth in H2.
Also, the new growth scenario will result in new estimates for the central bank rates. The US will be most aggressive by lowering interest rates by 150 bps over the next twelve months beginning with a cut of 50 bps on 18 March. In H2, the ECB will lower its interest rate twice by 25 bps.
Even though we have changed our macroeconomic scenario so that it now points to recession in the US, there are not that many changes in our strategy for the financial markets. And why is that? The reason is that the markets have already ”met trouble halfway” and for some months they have lowered prices in anticipation of the upcoming slowdown in growth.
However, the markets have not just fallen due to the anticipations of slow business trends, but also because the ongoing credit crisis, which started in the spring of 2007 due to the so-called subprime loans, has not been resolved yet. Equities, government bonds and particularly corporate bonds have discounted the bad news, while it has come as a surprise how well EM bonds and particularly the commodity market - particularly the oil market - are holding up. This is excellent news to the investors with exposure to these markets, but if nervousness increases further, some of these markets may be in for a correction.
We expect the dollar to increase further, because it looks undervalued - investor sentiment associated with the dollar is very negative - and because some of the flow into EUR will turn when the slowdown is felt in the euro zone. As long as the interest-rate gap and slowdown in growth seem to be worst for the US, the pressure on the dollar may continue for a while before things turn around.
On the whole, the largest changes will take place in the area of macro-economics, while our market views are fairly unchanged. With respect to portfolios, this is not the time to increase risk exposure as the credit crisis has not been resolved yet and the nervousness is extremely high.
The US
We have revised our view of the US economy and now we expect that growth this year will be at just above 1% instead of the originally expected level of 2.2%. The growth, primarily at the beginning of the year, will be downgraded and therefore we now expect that the US is or is in recession or is sliding into recession. With respect to interest rates, the consequence is that the Fed will lower its interest rate further by 1.5 percentage points in 2008 to 1.5%. In that case the real interest rate will be negative as has been the case during previous recessions.
The reason for our changed view rests on a combination of various factors. The most important reasons are that the crisis in the financial markets has lasted longer than expected, that food and energy prices have increased more than expected and that the companies have reduced employment as well as their investments faster and to a greater extent than anticipated. Due to the financial turmoil, it will become increasingly difficult and expensive for the companies and the consumers to borrow money and it is expected to put a damper on the increase in personal spending and investments.
The increases in energy and food prices offset the otherwise reasonable wage increases and that will normally put a damper on personal spending. Finally, we are surprised that the companies have already begun to reduce employment and investments that strongly despite the fact that non-financial companies are still in a good shape reporting large profits, low debts and fairly low inventories relative to sales.
It is expected that growth will be negative in H1, but we still expect that the development will become more positive in H2. This is based on the positive effect from the tax cuts and the delayed effect from the Fed's interest-rate cuts. Thus we expect somewhat stronger growth in H2 and thus the recession is expected to be fairly short-lived and fairly mild.
Euro zone
It does not seem as if the euro zone is in for a tough beating even though the US slides into recession. We assess that the negative spillover effect from the US to the euro zone will be of the same strength as previously. This is due to several factors: One of the crucial ones is that the US is less important to the export from the euro zone than was previously the case. In 2001 - during the past recession - the US accounted for 17-18% of exports from the euro zone. Today it accounts for less than 13%. Other reasons are that the labour market is strong, global economic growth is solid and capacity utilisation on the part of the companies is high at the same time as the order inflow is decent even though on the decline.
In our view, the economic growth in the euro zone seems to be weaker than expected previously, for one thing, due to the slower growth in the US, but also because the high inflation in the euro zone puts a damper on the purchasing power of the households and growth in personal spending. It is expected that economic growth in the euro zone will in 2008 be at 1.4% as compared to the previous estimate of 1.8%.
We assess that the weakest growth will take place in the middle quarters of the year when it will be considerably below the potential rate. Therefore we assess that at that time economic growth will have been below the potential level for four quarters on end. This puts a damper on the inflation pressure as we also expect that the falling unemployment will stabilise and prospects are that it will rise slightly in H2.
Therefore we assess that wages will not rise as strongly as feared by the ECB. If, on top of this, we do not expect energy and commodity prices to continue rising at the pace we have seen until now, we expect that inflation will be heading for 2% at the end of the year. Due to this and the lower growth prospects, we expect that the ECB will “fire the interest-rate weapon” and announce two interest-rate cuts of 0.25 percentage point in Q3 and Q4. The reason that the interest-rate cuts are not expected to be higher is that we do not foresee that the euro zone will slide into recession - and nor do we foresee an inflation rate considerably below 2%.
But the risks associated with the interest-rate estimate are to the upside. A direct consequence of continuing increases in energy and commodity prices will be a higher inflation rate. Yet also a higher risk of a stronger impact from second-round effects, e.g. from labourcontract negotiations and higher indirect product prices. And then the interest-rate estimate may change if the growth indicators remain robust, i.e. if we see higher-thanexpected growth decoupling between the US and the rest of world.
The downside risk associated with the interestrate estimate is that growth may fall to a rockbottom level at the same time as the inflation rate increases. This might happen if the commodity prices are subject to a major setback, if considerable tightening is seen with respect to credits in the euro zone, if the recession in the US turns out to be more deep and longer-lasting than expected and the decoupling to the US is weaker than expected.
Fixed-income markets
Recently the fixed-income markets have begun to panic. Prices of government bonds have increased at the same time as the value of other fixed-income assets has fallen. Subprime, credit, liquidity and most recently financial crises have triggered the flight to a safe haven. Particularly the yield on short-term government bonds has fallen as poor key figures also affected the growth expectations of the interest-rate market. This resulted in very high volatility. Even Danish mortgage bonds have been affected by portfolio adjustments and falling prices while the prices of government bonds have been on the increase. With respect to government bonds, the development has resulted in remarkable changes. In the euro zone, the interest-rate gap has widened to such an extent that we can almost talk about 1st and 2nd class securities. For instance, the 10-year interest-rate gap between Germany, Italy and Greece has almost doubled this year. At the turn of the year, the yield premium of investing in 10-year Italian and Greek government bonds was almost 30 bp. Now a yield premium of almost twice this magnitude can be obtained - without any currency risk.
The money markets in the US and Europe are still not operating normally. Following the strong turmoil at the turn of the year, we have seen a period of less tension. Unfortunately, it seems that the turmoil in this part of the market is flaring up again. The interest rate on unsecured loans in the money market has increased again. Therefore we have seen central banks undertake massive commitments with respect to liquidity in order to stabilise the money markets.
As long as there is turmoil, we will see wide, daily fluctuations of short as well as long-term government bond yields. The fear will eclipse anything else, but it will not last. At some point, the markets will focus on other issues than problems and vanished values. We expect that the inflation prospects will be a theme in the market. Despite the dampening effect from lower growth, we predict that interest rates will increase due to the inflation prospects. In the US, the inflation expectations on the part of the financial markets are now at the highest level since mid-2006.
We still assess that the current interest rates are low, not just in nominal but also in real terms. It cannot be ruled out that the interest rates will fall further, but in our view this will only be for a short while. For quite some time the markets have discounted an economic setback in the US as well as Europe. Only if we see a surprisingly long-lived and deep crisis, the long-term interest rates will stabilise at a lower level.
FX
The continued high financial volatility has left its mark on the developed FX markets. Especially USD reached rock bottom vis-à-vis EUR to the effect that it is currently flirting with the lowest levels in 30 years. As long as the illusion about a total economic de-coupling from the US economy remains uncontradicted, USD will generally be punished until the market sentiment turns sufficiently extreme!
The current extreme sentiment which is of both a psychological and fundamental nature may still turn out to open up for a much-needed correction. Should such correction change into an actual trend change for USD, it requires that the Americans start turning their enormous capital flow towards domestic shores. So far, it seems that a change of the ECB’s present monetary policy is long in coming, which has been an important factor behind the recent increase in EUR/USD. For the time being, we maintain our positive view of USD.
The all-pervading volatility has over the first months of the year forced the funding currencies CHF and JPY higher. Especially CHF has increased sharply, and therefore our original target areas have not been ambitious enough and have therefore subsequently been adjusted. Over the coming months, we see this trend towards stronger funding currencies continue unabated, yet with JPY in the leading part this time.
GBP is still under pressure by concern about the actual situation of the UK economy, of which we see no immediate clarification in the coming months, and therefore GBP will still remain in the doldrums. The same applies to NOK and SEK which are also suffering from the generally high volatility.
Commodities
Without comparison, commodities have been the winning asset category since year-end with for instance crude oil, copper, aluminium, soy beans, wheat, corn and gold trading at historically high levels. A trend which is basically due to a tightening of the fundamentals for several of the commodities, but a trend which is also due to a movement into commodities among speculative investors who desperately seek alternative return prospects.
In the short to medium long term (0-3 months) we see a material risk of a price correction. The long-term strong fundamental case on commodities has in a relatively brief period of time attracted many investors to the asset category. Consequently, the prices have risen somewhat steeper than indicated by the trend in fundamentals according to our assessment. This combined with the recession-like state of the US economy as well as the prospects of a relative sharp strengthening of USD , it is expected to contribute to the potential correction. The timing is, however, extremely difficult, and it is definitely not unrealistic that the current positive sentiment in the short term may contribute to further price increases.
Despite the possibility of a correction we are still moderately positive with respect to the prospects for 2008 as a whole, i.e. marginally higher prices at year-end compared with the current levels. The growth in demand in the development countries will more than compensate for slower growth in demand elsewhere (primarily USA), whereas supply disruptions and rising production costs will limit the growth in supply. The correction, which may in no way be interpreted as a collapse in prices, cf. our estimates (see the last page), will hence make room for a potential test of the current record-high levels at end-2008.
Equities
2008 has so far been a very bad year for equity investors. Hence, they unfortunately share destiny with a number of high-risk assets. The prospects that the US economy is running ”in reverse” and that the resultant risk of a negative trend in corporate earnings has left its mark. This has been one of our main arguments for keeping equities in their neutral base.
The declining equity prices and great investor jitters are due to the uncertainty about the US economy and also the global economy. The bad news is that the uncertainty will remain high for a period of time. The good news is that the financial markets have - true to tradition - already anticipated the bad situation.
As a natural consequence of the slightly darker prospects for the economy - and not least that we did not start off at zero, but comfortable in negative territory - we have downgraded our expectations of the development of equities in 2008. This does not have any effect on the longterm prospects. But within the year it is now realistic to assume that the European markets may enter into negative territory. The Danish market at level zero whereas it is still not unrealistic that US equities will later in the year focus intensively on the period of time after the recession than on the present challenges - and hence still have an actual possibility of ending the year in positive territory with respect to return.
Emerging markets
A US recession is negative news for the emerging-market universe. Previously, recessions in the Western countries have been a great problem for the export-oriented emerging markets. We expect the impact will be lower this time. But emerging markets cannot fully decouple from the industrial countries which has, nevertheless, been the subject of many speculations. For the full year, we expect to see a return in local currency of 8% at index level, Whereas the return in core currency is expected to come out around 5%-6% in USD terms for emerging-market bonds.
Emerging-market countries have changed markedly over the past 10 years. The emerging markets have made their central banks independent so they now use inflation targets. Strong global demand has led to rising commodity prices, which combined with a more balanced fiscal policy, have created a surplus (or a lower deficit) for the current accounts of most emerging-market countries. This has made emerging-market countries attractive for investment purposes, and when capital is flowing in, the currencies strengthen and put a damper on inflation through cheaper import prices.
How do the developed countries affect emerging markets?
1/ The economic coupling is the traditional coupling through foreign trade and the manufacturing industry. 2/ The financial coupling means that slower growth in the developed countries results in a fall in investors’ risk tolerance.
The emerging markets will be affected by slower growth in the US and Europe Traditional models indicate a one-on-one correlation. If the development in 2007 is partly repeated in 2008, the financial markets may offset some of the slowdown in growth in the emerging markets. Should risk aversion rise substantially, the emerging-market bonds and currencies will be hit to an extent never seen before. Countries with current-account deficits, comprehensive trade with the US and a high proportion of foreign investors in their financial markets are most vulnerable. Therefore it is important to be selective in the emerging-market universe which we already mentioned in our January issue. Mexico and Malaysia have considerable trade with the US, and Turkey and South Africa, have large current-account deficits. In addition, we expect that investors will have better opportunities of enhancing their risk exposure to the emerging markets in H2 as opposed to the present time where it is sensible to adopt a more hesitant strategy.
Corporate bonds
In the corporate bond and credit markets got off to a hard start to the year. The background behind the weakness year to date is the credit crisis and its impact on the US economy. The development has been characterised by solid spread widening. At present, Itraxx Xover (index of European Credit Default Swaps - or in other words the price of insurance against bankruptcy) is at 610 which is far away from the target of 450 at mid-year and 425 at year-end.
With respect to the long-term development, the credit market does boast some value. But we cannot expect a one-sided stabilisation or upturn, we have still not come that far. The present scenario is that each company must fight harder to earn money, raise funds and accommodate market expectations. What determines the long-term trend is fundamentals, and with respect to credit this is personified through the default rate on loans. This rate bottomed out below 1% in December, but it is slowly increasing, and this trend is expected to continue. Currently, the market indicates that it will go up to 6%-7% within the next 12 months. Currently, the figure is now 1.8%. Given depth and width in the market, many companies, very many companies indeed, must go bankrupt.
The global climate and especially the climate in the US is not favourable since the possibilities of re-financing /assistance from banks in situations of crisis are limited. On the other hand, corporate America or corporate World is not in consolidation mode yet. The focus is always on optimisation, but we have not yet seen any reductions or withdrawals of dividends or investment programmes. The effect of these initiatives, when they are launched, will eventually bring positive support to the market.
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.
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