Strategic Outlook: Sand in the Growth Machinery

Economic growth

The turmoil in the financial markets has now lasted for a couple of months. Especially the money market has been hit, and hence the spread between money-market rates and government bond rates has widened considerably, see chart. There are no signs that the confidence crisis in the money market will disappear tomorrow or the day after tomorrow.

Amidst the turmoil in the financial markets, a surprisingly poor US job report was released, showing sluggish employment growth in recent months and the first decline in employment in one single month since 2003.

The job report fuelled the uncertainty about economic growth deriving from the financial turmoil. The employment figures indicate that the US labour market had weakened already before the financial turmoil began.

On the basis of the financial turmoil and the weak employment figures, we downgraded our expectations of global economic growth, see table. Now, we anticipate economic growth around 2¼% in the US in 2007 and in 2008.

The growth estimates are more uncertain than they usually are, among other things, because it is uncertain how long the financial crisis will drag on. The longer the crisis, the stronger its impact on economic growth. Our forecast is based on anticipations that the crisis will be over in a couple of months.

The uncertainty about the growth estimate is wider on the downside than on the upside, and the risk of a recession in the US has increased. The risk is not insignificant.

Still, the recession in the US is not our main scenario. There are several reasons why: Firstly, the fall in residential construction will eventually come to an end and no longer depress economic growth. Secondly, corporate profits are still solid which benefit employment and investment. Thirdly, we see fair economic growth in the rest of the world which supports US exports. Fourthly, we expect that the Fed will lower its interest rates so much that it will have a noticeable impact on economic growth.

The slower growth in the US will, combined with the financial crisis, slow down economic growth in the rest of the world. Consequently, we have also downgraded our growth estimates of the euro zone and Japan.

Among the three large countries, only Japan can next year look forward to economic growth above the long-term average. Still, global economic growth seems to come out above normal thanks to a fair development in emerging markets.

Central Banks

In consequence of the financial turmoil, the downgraded growth estimates and the Fed's surprisingly big interest-rate cut on Tuesday, we lower our expectations of the central bank rates.

The Fed made the first move by lowering its rate from 5.25% to 4.75% as the central bank is of the opinion that there is a risk that the financial crisis will put a damper on economic growth. We now expect that the Fed will follow up on this and announce an interest-rate cut of 0.25 percentage point at its October meeting provided that the financial turmoil has not abated markedly. Moreover, we anticipate two interest-rate cuts in early 2008.

With respect to the euro zone, we assess that the ECB will maintain its interest rate at 4%. The ECB was close to the peak already before the financial turmoil began and due to the weaker economic growth prospects and increasing uncertainty about the economic development, there is no longer any need to raise its interest rate further.

The interest rate in Japan is very low and we still assess that the BoJ maintains its tightening bias. However, we expect only one interest-rate hike until the end of 2008.

The financial markets in general

Volatility and risk premiums have increased in step with the financial turmoil. In combination with the increasingly uncertain growth prospects, this will affect the financial markets also over the next couple of months.

Until the turn of the year, prospects are generally that we will see lower returns than the financial markets have grown accustomed to in recent years. Also, it is to be expected that volatility will remain relatively high. This is an indication that investors should be particularly careful over the coming months.

Market rates

The 10-year yields on government bonds have fallen quickly and markedly over the past three months, during which investors have fled to safe securities. The US rates have moved from 5.29% to - so far - a bottom at 4.32%, while the decline in Europe was not quite as pronounced.

Given our expectations of the central bank rates in the US and Europe, the current low level of the 10-year yields will result in very flat yield curves in the slightly longer term. We do not think this will be the case, however. As the financial turmoil abates, we expect steeper yield curves and therefore rising longterm rates in the US as well as Europe.

We expect that in the 6-month term, the 10- year yields in the US will be in the range of 4.25-5.25%. We expect that in the euro zone the yields will be in the range of 4-5%.

Thus, the current rates are close to the bottom of our expected ranges and interest-rate hikes are more likely to take place than further declines. Increases in market rates are more probable after the turn of the year than before as the risk of continuing financial turmoil will fall as time goes by.

Credit markets

Over the past weeks, the credit market has been fairly stable even though we were able to detect some nervous sentiment. Over the coming months it will be crucial for the market whether and when confidence in the financial system can be restored. The longer the time, the worse the development for the credit market.

At this point in time, it is still extremely difficult for companies with high debt ratios or risky business profiles to raise loans. However, the balance sheets presented by the companies still look solid after a period of extremely good business conditions. This will support the credit market. And so will the default ratio, which we expect will remain at a low level.

We have seen a long period of most attractive financing terms, and particularly over the past twelve months this has had the result that a rising number of corporate loans have been granted with a view to financing risky projects/investments. It will, however, typically take three or four years before such loans will become problematic and therefore we do not yet see problems caused by this group.

Also, we have seen the width and depth of the market expanding greatly in recent years, and therefore the risk has become much more diversified than was previously the case with respect to companies as well as and not least the investor base.

On the whole, we expect that the yield spread to government bonds will stay more or less unchanged over the coming months. This indicates positive returns on corporate bonds until the turn of the year.

Equities

Normally lower central-bank rates have a favourable impact on the equity market, especially if the basic prerequisites are at hand: equities must have fair valuations; investors must not be overinvested in equities; and global economic growth cannot be markedly decelerating.

The basic prerequisites for a positive development ARE at hand. Nevertheless we are slightly cautious with respect to the development in the equity markets for the short term (0-3 months). The reason is that a higher pricing of risk, as a result of the financial turbulence, may be a bit more harmful to the equity markets than investors may reckon.

We do not have a bearish view of equities, as equities are still a very attractive asset class. But we think there may be a risk that the markets may be disappointed about what to be expected from central banks in the short term. It is not the purpose of the central banks to support risk-tolerant investors.

We still believe that equity prices will be moderately higher at the end of the year. But we do not expect any markedly positive development over the coming months.

FX

The latest turbulence in the financial markets has caused renewed volatility in the FX market. At the time of writing, we only see one well-defined trend of the yen. The six-year long downtrend of the yen is over, and instead we see a paradigm shift in the form of a general strengthening of the yen. We expect this trend to continue over the next months.

Things are a bit more involved with respect to the dollar, but we nevertheless maintain our bullish view of the currency. Given our lower growth estimate for the US, an additional narrowing of the current-account deficit will point to a stronger dollar, just as a possible coming home bias among American investors may cause the international cash flows to turn with a resultant strengthening of the dollar.

Thus we do not agree with the current market psychology with respect to the need for a weaker dollar. It rather seems to be a further confirmation of our bullish view, since the dollar is currently strongly oversold.

Until we see a decisive breach of the level around 133 of the EUR/USD rate, we must, however, keep patient since trading in the range of 133-142 will still dominate the market.

Hence we also still expect high-yielding currencies such as AUD and NZD to weaken against the dollar. CAD has not followed suit yet with the two other currencies, but it is, however, expected that an American economy with slower growth will pose big problems for CAD.

In terms of funding, we still recommend a defensive portfolio due to the general rise in volatility. A clear clarification of the current financial problems is required before we will again open a more aggressive funding strategy.

Commodities

Commodities have proved a safe asset class lately when the financial markets have been turbulent - a development that supports our expectations that the rise in commodity prices is based on fundamental conditions.

A low US Fed-funds rate and slow economic growth have historically had a negative effect on industrial metals and energy, which is expected to be the case this time too.

However, we only expect a slight fall in prices, since the global growth rate will continue to be fair - not least among the so-called BRIC countries, chiefly China, which now account for the main growth in demand in the commodity markets.

Gold may benefit from the uncertainty in the financial markets, but a stronger dollar and a technically overbought picture limit the upside potential.

The crop markets are expected to move independently of the expected slowdown in economic growth. The price of crops will to a higher extent be determined by supply conditions like the weather in the short term.

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.