Strategic Outlook: Staggering Growth

It has now been a year since the international financial crisis really took off. The Fed as well as the European Central Bank have had to render assistance in the form of additional liquidity, and there is still a shortage of liquidity today - a year later.

At this point in time - a year after the onset of the crisis - the economic slowdown and the high commodity prices (particularly the oil price) have added to the financial crisis and the global economy is still facing big challenges.

What about the current situation? Well, it can be said that fear of low growth has now replaced the fear of high inflation. This development has taken place after the oil price fell by more than 20% from the peak in mid-July while at the same time we are being inundated with poor economic data for Europe, the UK, Japan, while the emerging markets are also seeing a somewhat weakening development.

What are the forces behind the global economic slowdown in addition to the weak US economy?

Global shocks = global effects

Drastically rising food and energy prices have put a damper on the consumers' purchasing power globally and reduced growth by 50% relative to the level in 2007. At the same time, the companies' earnings are under pressure due to rising commodity prices and wages.

The reaction on the part of the authorities

Despite the housing-market crisis, financial crisis, oil crisis at full blast in the US, it seems that the US economy saw stronger growth in H1 than the Japanese as well as European counterparts. An important reason for that is that the US authorities did all they could to avoid a slowdown in growth. The central bank lowered its interest rate markedly to 2%, and tax relief in the amount of USD 100bn were granted. Europe has seen an interest-rate hike and no easing on the part of the authorities.

“Prepared for the worst”

A new development was that already at the beginning of 2008, the US companies seemed to have begun reducing inventories and cutting labour costs in preparation of the bad times ahead. Apparently they were better prepared than the companies in Europe and Asia, which will have to make deeper cuts in production to adapt to the new weaker demand.

Investment Conclusion

A general theme for investors is positioning for continued weakening of growth outside the US Therefore, among other things, we now see a markedly stronger dollar as the trend has been reversed. That we prefer US equities to European ones and that European bond yields will fall towards the US level.

On the whole we keep the risk unchanged in the portfolio by maintaining neutral weight for equities. Our considerations with respect to the future are that we will rather prefer to increase the proportion of equities than to reduce it.

This autumn equities may be boosted by the lower inflation level. Moreover, the many global investors have reduced their holdings considerably. They may gain some appetite for equities when they see the favourable effect from the lower oil prices.

However, the challenges for the equity market is that slow growth will spread from the US to the rest of the world and put pressure on the companies' earnings and, moreover, the financial crisis is still not over.

USA

We now expect that growth will begin to increase at about the turn of the year instead of in the autumn as expected before. In the meantime, there are prospects of recession. It seems that, over the coming months, inflation will be a smaller problem due to falling commodity prices (energy and food). Falling inflation and rising unemployment will pave the way for a couple of interest-rate cuts on the part of the Fed.

The expected upswing has been postponed due to a mix of rising mortgage rates, higher energy and food prices, continuing strong financial turmoil and the fact that consumers have utilized a larger proportion of the tax cuts than expected. In Q2, GDP growth was quite solid, due to stronger personal spending, among other things, than we originally expected. It seems that the consumers have spent a larger proportion of the tax cuts than expected, but since July no more tax cheques have been issued and that will affect personal spending in H2.

Generally, the consumers are still facing stormy weather even though the storm has weakened a bit. The headwinds are in the form of falling employment, rising unemployment, lower housing prices, an increasing number facing payment problems and problems obtaining bank loans. The consumers have been severely affected by considerably increases in energy and food prices, yet as these prices have fallen, the pressure has weakened a bit. The nervousness on the part of the consumers is reflected in steeply falling car sales over the past couple of months.

Mortgage rates have increased since the beginning of the year in the wake of the turmoil in the mortgage-credit market. Together with continuing strong tightening of the banks' credit conditions vis-à-vis home owners in particular, this will put a damper on the demand for houses and thus delay the expected stabilisation in residential construction till Q4 2008.

On the whole, we expect that H2 growth will be negative and that the cyclical development will bottom out in Q4 and increase in the course of 2009. The biggest risk facing the economy is still the development of house prices and the ensuing losses in the banking sector.

The decline in commodity prices for energy and food will result in falling inflation rates over the coming months. Core inflation will also come under pressure due to a slowdown in wage increases, weak demand in H2 and reasonable productivity growth.

Weak growth over the remainder of the year will add further to the unemployment. We expect that the unemployment rate will rise from the current 5.7% to 6% at the end of 2008, while also for some time into 2009 there is a risk of rising unemployment.

The mix of falling inflation and rising unemployment will add to the pressure on the Fed to lower its interest rate and we expect interest-rate cuts of 0.25 percentage point in Q4 2008 and in Q1 2009.

Euro zone

The winds blowing over the euro zone are becoming increasingly cool - almost chilling. This weather change seems to be pronounced. The year came off to a strong start with growth of 0.7% q-o-q, but then we saw a weak level at -0.2% in Q2. However, special circumstances such as the mild winter, etc. had an impact on the two quarters. However, the average growth of 0.25%, q-o-q, in H1 is a definite signal that the growth is on the decline and is somewhat below the long-term growth rate.

Together with a slowdown in the global growth, the high inflation has had a slowing effect on growth. And with the prospects of continuing high inflation - which very well may have peaked this time around at 4.0% - we do not expect that in the foreseeable time the ECB will lower its interest rate to stimulate growth. The bank is still very concerned indeed about second-round effects in the form of accelerating wage increases. We do not expect that the inflation rate will get close to 2% until mid- 2009.

A much needed stimulant in respect of the purchasing power of the households has been seen in the form of falling commodity prices for oil and food. Also, there are prospects that wage increases will accelerate, which will support private consumption and thus economic growth. On the other hand, the historically strong labour market is about to turn around, which indicates that we will get a slightly weaker growth stimulant from this market.

Exports are under pressure due to weaker global growth, weak competitive power due to the strong euro and rising unit wage costs. Therefore the expected weakening of the euro will be most welcome with a view to boosting competitive power and exports, as the increase in the unit wage costs does not seem to have peaked.

For quite some time, the growth in investments has been solid, yet there is hardly any doubt that the weak housing market is beginning to have an impact. It is expected that business investments will come under pressure. The companies are under pressure due to the tightening of credits, accelerating wage increases and increasingly gloomy growth prospects. This will put a damper on investment growth over the coming quarters.

We may also see relaxation of the fiscal policy - particularly in Spain - where there are indications that measures will be taken to assist the ailing construction sector and economy. Thanks to the decent public-sector surplus, this should be possible. In Germany there have been many rumours about tax cuts in 2009, but for the time being Angela Merkel maintains that such measures will not be seen until 2010.

Due to the weaker-than-expected growth scenario seen in the euro zone and the somewhat protracted slowdown in growth in the US, we have downgraded our growth estimate for the euro zone to 1.3% for this year and 1.1% for 2009.

As it is expected that the inflation rate will remain high for quite a while yet and as the unit wage costs are expected to increase, we do not believe that the ECB will attempt to boost growth until Q2 2009. We expect that over the three last quarters in 2009, the ECB will announce three interest-rate cuts of 0.25 percentage point.

Japan

Economic growth in Japan is in the doldrums.

The export sector has been hit by the global economic slowdown, and there are no prospects that the domestic economy will take over the role of growth engine.

Private spending is under pressure by poorer employment prospects, and falling real wages due to rising inflation and low nominal wage growth erodes households' purchasing power. In addition, the weaker prospects of private spending and export investment are a burden, and profits in the business sector are squeezed by high commodity prices. The fact that approx. 50% of Japanese exports go to Asian emerging markets - which we expect will maintain a growth rate in line with the trend - still supports the export sector despite the slowdown in the global economy.

All in all, we believe that the slowest growth will materialise in Q2 and Q3 2008, but that growth will subsequently only gradually be on the increase. For 2008, we expect to see a growth rate of 1.1% whereas economic growth will in 2009 come to 1.3% and hence stay slightly below the potential growth rate.

Even though consumer prices have risen significantly by Japanese standards (2% y/y) and are now at the highest level for ten years, there are no signs that inflation is generally on the rise. Underlying inflation (excl. of food and energy) and wage growth will hence remain around zero, and despite the increase in consumer prices Japan has therefore still not left the shadow of deflation.

We expect that the Bank of Japan will leave its interest rates unchanged at 0.5% for the coming quarters. An interest-rate hike is not expected until the second half of 2009, when either growth has picked up again, or core inflation begins to show signs of a clearly positive trend.

China

Seen in the light of a major slowdown in economic growth, Chinese exports will come under heavy fire in the coming months. Given a weaker export sector, and presumably also weaker investments in the private sector as well as slower activity in domestic propertyrelated activities, we anticipate a moderate slowdown in economic growth. By Chinese standards, moderate still means economic growth above 8%, and for the rest of the year, the growth rate will presumably be around 9%, i.e. a growth rate just below 10% for 2008.

International investors have been concerned that the Chinese government would react too slowly to growth risks and that this would send up the risk of a serious setback (i.e. GDP growth rates much lower than 8%). Such fear seems to be out of place, based on the demand figures for July. Foreign trade, retail trade and fixed investments beat expectations although industrial activity is gearing down marginally.

The Chinese authorities have traditionally introduced macro-economic policies supporting economic growth, including an expansionary fiscal policy, monetary-policy easing etc. to avoid a hard landing. We also expect that this will happen this time if growth seems to be too slow. The authorities have recently raised the tax benefit on exports and eased up the tight management of corporate loans in the financial sector.

On the domestic front, the trend in consumer demand is still impressive: July's 23.3% growth in retail sales was higher than expected. This happened although consumers are squeezed by higher food prices, the solid correction in the Chinese equity market and a slowdown in the real-estate market (although the impact from the two last-mentioned factors was reflected in lower sales figures for cars, furniture and building materials).

With prospects of a moderate slowdown in industrial activity in the coming quarters, the growth in Chinese demand for many important commodities will presumably slow down. Recent data indicate that this trend has already set in: for instance crude-oil imports dropped back by 2.1% m/m in July and by 8.7% in June whereas iron ore imports dropped by 4.2% and 3.5% in these two months.

Interest rates

Short-term as well as long-term government yields fell back over the summer. The market sentiment has changed between fear of inflation and fear of a massive slowdown in economic growth. Currently, the markets are focusing on the risk of an economic slowdown.

Recently, this sentiment has particularly dominated the European interest-rate development. Interest rates in Europe have dropped back by more than in the US. This is a development that will in our view continue so that long-term interest rates will be at the same level and maybe even end up falling below US interest rates.

Expected interest-rate trend in the euro zone

The money markets are far from functioning optimally. We see a lower level of trading and at interest rates that are considerably above central-bank rates. Central banks have therefore opened up for the procurement of liquidity against the banks providing security in a wide range of securities. In the US, the Administration has intervened to rescue the real-estate sector. In our view, all efforts are dedicated to bringing about a normalisation of the markets. So far, we must, however, prepare ourselves that investors will be hesitant assuming additional risk.

The present market sentiment is therefore down for interest rates although we see increases in inflation which have not been seen for many years. Still, the market is convinced that general inflation will flag off quickly and approach underlying inflation. This assessment is reflected in the inflation expectations of the financial markets which over the past month dropped back to just above 2% p.a. in the US and in Europe. If the market turns out to be too optimistic about inflation, we will see a counter reaction up on interest rates. This will particularly be the case if we also see hope that the crisis in the financial sector has peaked.

Due to the above, we have lowered our yield estimate for both the US and Europe. Hence, we have reduced the yield band by 0.25 percentage point for 10-year yields in the US as well as the euro zone. Therefore, we make slightly more room for more negative surprises from the financial front.

For the longer term, we still believe that the current market rates are low.

FX

The trend of the US dollar is in the process of making a historical turn. The dashed illusion about a decoupling in the global economy has really highlighted the dangerous balancing act of especially the European economy at the moment. Hence, EUR has lost the majority of its allure vis-à-vis USD which is now instead increasing the distance to the recent historical bottom in mid-July of 465.15 (160.38).

The new uptrend is not only based on the new misery in Europe but to a great extent it is linked to the globally important financial and economic role of the dollar.

Due to the downtrend of almost seven years of the dollar and the expansive monetary policy once again embarked upon by the Fed has caused many international investors to take up loans in USD. However, because of the recent impressive increase in the dollar value, it is no longer possible just to reckon with a continuing decline in the value. An actual closedown of the dollar funding may thus turn out to offer strong support for the dollar.

The gloomy future prospects for the US economy have also resulted in a turn in the US investors' heavy capital flows away from the global financial markets toward the domestic shores and this will also add to the demand for USD.

Moreover, the previous apparently inexhaustible flow of USD to the rest of the world due to the insatiable spending on the part of the Americans is quickly drying up as the US current-account deficit narrows. Thus the amount of USD in circulation is on the decline.

Therefore we do not only foresee generally higher USD rates but also continuing high volatility in the FX market for quite some time to come. Often new trends emerge during strong volatility. The older and the better established a trend has been, the wider the fluctuations - and until now the FX market has very clearly demonstrated that this is so. Thus the heyday of the euro at the expense of the dollar has come to an end this time around.

Commodities

Within the past few months the oil price hit a new record at USD 147 a barrel, only to plunge by more than 20 per cent.

In our Mid-year review of May we maintained our expectations that the oil price would correct back in the course of the second/third quarters in line with the deterioration of the economic indicators. Also, we held that expectations of a signally stronger dollar would squeeze several speculative investors out of the market. That is exactly the scenario we have witnessed.

Oil is now trading within the range of USD 110- 120 a barrel, and from this point we see limited potential of additional falls. We expect considerable buying interest, if the price moves down into the range of USD 100-110 a barrel, and this may cause crude oil to bottom out for the short term. It is still demand from Asia and the Middle East that is the main driver. Moreover, it is important to stress that the long-term fundamental structural problems in the oil market still prevail. Those problems will keep oil prices permanently high for several years, and they support prices above USD 100 a barrel. We now expect the average oil price for 2008 and 2009 to be USD 117 a barrel for the US reference contract (WTI).

For the past two or three months, the arrow in the metal markets has been pointing down while fears of a considerable fall in economic growth have got the upper hand in the financial markets. The bearish sentiment may in the short term cause additional falls in base metal prices. However, prices close to marginal costs and prospects of slower growth in supply are expected to limit the downside of aluminium and nickel, while the upside on the copper market depends on how long the Chinese importers keep to the sidelines. Until then, the price of copper may well test USD 7,000 a tonne on the downside. We expect copper to trade at USD 8,000 a tonne at the end of the year. A more positive view on the dollar means that we reduce our expectations of the gold price to USD 750 an ounce by the end of 2008.

Unlike expectations, the extensive floods in the Midwest of the US did not result in a sweeping reduction of the corn crop estimate. Therefore we reduce our expectations of corn to USc 650 a bushel by the end of the year. Our expectations of wheat and soy beans are maintained at USc 940 and USc 1,450 a bushel, which means an upside of 5-12 per cent on those crops.

Equities

The financial conditions for companies and consumers have improved slightly in recent weeks because energy prices have been falling. Nevertheless, equity prices have shown only very slight signs of rising. This is partly because of the persistent challenges in the credit markets and because investors still fear that commodity prices may begin to rise again. The expected fall in earnings in coming quarters does not exactly make life easier for equity investors either.

Still, there are bright spots in the gloom. The falling commodity prices result in lower inflation expectations which, other things being equal, will spill over into lower central bank rates. That will justify higher equity-to-earnings ratios. Assuming relatively unchanged commodity prices for the rest of 2008, we regard it as the most realistic scenario that equity prices rise by 5%-10% towards the turn of the year.

Emerging markets

No doubt the recent falls in the price of oil (and other commodities) have had a positive effect on the emerging markets. Lower commodity prices have eased pressure on the global consumer and on inflation and hence on the central banks.

A number of central banks have already indicated that the period of interest rate hikes is over, and we note expectations of significant monetary policy change at the world's central banks and resultant massive falls in interest rates in the emerging markets: two-year swap rates are down by approx. 50 bp in Poland, Iceland, the Czech Republic and Brazil, by approx. 100 bp in South Africa and Colombia and by no less than 135 bp in Turkey.

Given the fact that the emerging-market currencies have come out in fair shape, the emerging markets have performed well lately, and local-currency bonds have generated a yield of 5% for the year to date. Overall, the fall in commodity prices has improved the prospects for the emerging markets. If the commodity prices do not rise again, the inflationary pressure will peak in Q3-Q4.

However, the fact that global prospects of growth have deteriorated lately pulls in the opposite direction. We have not seen the full effect on global growth of the credit crisis (particularly in the West) and the oil shock (particularly in the emerging markets where commodities account for a bigger proportion of the consumption basket).

All in all, we expect the return on local-currency bonds at index level to be around 8% for the year. But it is likely that the Yellow Jersey will pass on: whereas chiefly Central and Eastern Europe have performed well, the economic slowdown in the euro zone and the expected fall in the EUR/USD rate prompts us to regard Latin America as the most sensible region for future investment.

Corporate bonds

At the end of July, the global default rate had risen to 2.5%. This means that it had risen by about one percentage point since it bottomed out in 2007. This is still markedly below the long-term average of about 4%. But the rate will continue to rise as has been discounted by the market. At the time of writing, the price of global High Yield bonds discounts a default rate of about 9%, which is about the level envisaged by Moody's. It must be expected that, since banks are relatively reluctant to lend money, the rate is likely to ratchet up significantly over the second half of the year, but there is room for that, too.

The latest survey of US lending standards indicates very difficult credit conditions. Activity has been very moderate in August and liquidity has been thin. Equity volatility has been falling, although we have not seen yield spreads narrow. This may be because of the summer, but also the fact that the epicentre of the financial crisis is still the credit market.

If equity volatility remains at the current levels, we expect corporate bond prices to edge up when the holiday season is over.

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.