Strategic Outlook 2008: A Rocky Ride

Outlook for 2008

Here at the beginning of 2008 the uncertainty about the development in the financial markets has not been higher in several years. This uncertainty has resulted in falling equity prices, lower yields on long-term government bonds and widening yield spreads. The uncertainty has been fuelled by concerns about a recession in the US as well as continuing turmoil in the banking sector and the money market.

In our assessment there is no indication that the uncertainty will disappear in the short term. Concerns about a recession the US may continue for quite some time into H1. Nervousness about further announcements of losses on the part of banks may trouble the markets. In that respect the housing market in the US, in respect of the risk of rising unemployment and falling house prices, is very important. Undoubtedly, this theme will not be exhausted in the short term. Moreover, we will see some uncertainty with respect to the development of the companies' earnings. Finally, the slowdown in growth in the US may result in concerns that the slowdown in growth may spread to the rest of the world.

The uncertainty has triggered reactions on the part of various monetary and fiscal authorities. The major central banks all over the world have attempted to calm down the turmoil in the money market by injecting additional liquidity and the money-market rates have fallen.

However, the spread between the moneymarket rates and the central-bank rates are still wide, as appears from the chart below. Most likely the spread reflects distrust on the part of the banks, and to a great extent the central banks do not have much power over these banks. This distrust will not disappear until we get a better idea of the potential losses in the financial sector.

The US central bank has been the most aggressive player to combat the turmoil. It has already lowered its interest rate by 1 percentage point and we may see further cuts. Also, the fiscal policy may be relaxed in the US, yet it applies to all these measures that they will have a limited impact on economic growth in H1.

Generally we expect that the difficult H1 will put a damper on investors' willingness to invest and thus also on the financial markets. We recommend that investors are cautious at the beginning of the year.

The prospects for economic growth in H2 are brighter as the Fed's interest-rate cut will begin to be reflected to a greater extent and housing construction is expected to stabilise. This will reduce uncertainty, and it is expected that the improved growth prospects will lead to stronger risk appetite on the part of investors.

Generally we expect an uncertain H1 in the financial markets, but this period will be followed by a more positive H2. It is expected that equity prices will recover and rise by 5-10% over the year. Also, we predict generally higher long-term yields and it is on the cards that the US dollar will strengthen. Finally, chances are that we will see decent returns on EM and commodities, while prospects are a bit more subdued with respect to corporate bonds.

The US

The US has embarked on what seems to be an uncertain and difficult year with respect to the economy. Particularly H1 will offer challenges and the risk of recession is quite considerable (40%). Chances are that economic growth will be invigorated in H2.

A number of challenges will arise, particularly for consumers, in H1. Oil prices have gone up considerably, the turmoil in the financial markets and among the banks is relatively strong and many homeowners who have taken out floating-rate sub-prime loans will be facing higher interest expenses. Moreover, we may be in for a moderate increase in unemployment and slightly lower increases in wages. Also, consumers will be under pressure from the housing market, as there is a risk of downright declines in house prices.

Basically, the corporate sector is in good form. This is important as, due to falling investment on their part, companies are often the ones that push the economy into recession. Profits are high, debts have increased to a limited degree while assets have increased quite substantially in recent years. Also, based on the short-term indicators the order books are thick and inventories are not that high. International economic growth is still reasonable and, together with the weakening of the US dollar, this will sustain exports.

On the whole, these factors will result in very moderate growth in H1.

While economic growth seems to be in for challenged in H1, the prospects for H2 seems brighter. The interest-rate cut on the part of the Fed will begin to be reflected and the marked decline in housing construction is expected to come to an end. Moreover, oil prices will not constitute the same burden to consumers.

We expect the Fed to cut interest rates twice over the spring. This may seem fairly moderate, but the bank has already lowered its rate by 1 percentage point, of which the first 0.75 percentage point was an insurance premium against weaker economic growth. However, if the US slides into recession, we expect the Fed to lower its interest rate to about 2%.

Euro zone

Economic growth in the euro zone has fallen gradually since the summer of 2006. The growth rate is already at about 2%, i.e. corresponding to the long-term average. We expect that economic growth will fall further in H1 2008 and then it will recover in H2.

A number of factors will have an adverse effect on economic growth over the coming months, including strengthening of the euro, declining growth in the export markets, high oil prices and the credit crisis. We expect, however, that the impact of these factors on economic growth will gradually diminish. Moreover, we expect that the strong labour market with the lowest rate of unemployment in many years will contribute to a slightly higher level of consumer spending over the year.

On the whole, we expect economic growth of 1.8% in 2008. This implies a fairly pronounced slowdown in growth relative to 2007, for which its seems that growth came to 2.6%. The economic growth rate will, nevertheless, be close to the long-term average.

Due to the slowdown in growth, the inflation pressure will be alleviated somewhat. However, the growth rate will still be so high that the ECB sees a risk of rising inflation over the coming months. This must be viewed in the context that high oil and food prices have currently resulted in an overall inflation rate above 3%. The ECB fears that this will spread to the inflation expectations on the part of the companies and the consumers and thus result in a more permanent inflation problem.

We expect, however, that due to the more uncertain growth prospects the ECB will maintain its interest rate at 4% over the coming months despite the risk of inflation. The uncertainty with respect to that estimate is to the upside.

We expect that inflation will fall over the year and at the end of the year the inflation rate will be at about the target of 2%. Due to the expectations that the economic growth will recover at the same time, there are also prospects that the ECB will maintain its interest rate at 4% in H2. The uncertainty with respect to this estimate is to the downside, primarily because we see a strong risk of recession in the US.

Interest-rate markets

The fear of recession affects the interest-rate markets at the beginning of the year. The longterm yields have fallen over the past six months, yet with interruptions and counterreactions. Undoubtedly the uncertainty will still be considerable. We also expect that 2008 will offer considerable and fast-paced changes in sentiment. We expect that H1 will see the lowest levels of the market rates.

Later on new hopes of economic progress will result in increases in the long-term interest rates. In that respect, it will be decisive how the market players assess the inflation prospects. Due to increases in energy, commodity and food prices, the current inflation rate is fairly high. We may see periods in H2 when the market becomes nervous about the inflation prospects.

Since the summer of 2007, the short-term money-market rates have been unusually high relative to the central banks' interest rates. The decisive thing for normalisation of the interest rates is that confidence is again established among the market players. The central banks may help by playing an active role in the daily realignment of liquidity, but it is difficult for them to affect confidence among banks. A higher degree of confidence among the parties in the money market is decisive for normalisation of short-term rates. Most likely, it will be quite some time into 2008 before the problems in the money market are solved.

Over a period, we have seen considerable fluctuations in the market rates and we expect this trend to continue in H1. The considerable fluctuations result in a wide spread between the expected highest and lowest interest-rate level. Below we have outlined the expected interest-rate development in the euro zone and a more or less similar development is expected in the US.

Currency

We interpret the most recent high volatility in respect of the US dollar as an indication that the downtrend for the dollar is coming to an end and instead it will be followed by a new pronounced uptrend. This will require a decisive breach of 137 for EUR/USD or 544 for USD/DKK. We expect to see such a breach over the next three months. We foresee that subsequently the anti-cyclical dollar will continue to increase over the coming months and at least test 130 against the euro (573).

If, in line with out main scenario, the US economy succeeds in having a soft landing instead of sliding into recession, we expect that the US dollar will be subject to renewed sales pressure in H2 due to rising risk tolerance. Under our main scenario, we foresee that the dollar will peak at about 130 (573) and subsequently it will be pushed towards 135- 137 (544-552) at the end of the year.

On the other hand, in our risk scenario assuming that the US economy slides into recession, we foresee that the dollar will continue skyrocketing to test at least 125 (596).

High risk aversion and high volatility is poison to the two funding currencies CHF and JPY. Due to the most recent exchange rate increases, both currencies are now in the process of actual trend changes against the euro. We expect that the exchange rate for the CHF will continue to increase in H1. Revisiting levels at about 158 for EUR/CHF (472) before the end of H1 is therefore realistic and subsequently CHF is expected to gradually weaken again. If the risk scenario materialises, we foresee that CHF will strengthen up towards 481 (155) at the end of the year.

The yen offers quite a different story. The current trend change for EUR/JPY is expected to have more far-reaching implications for its status as funding currency. We foresee that in H1 the yen will increase towards 145 (5.15) and at the end of the year it will be at about 130 (5.75) - irrespective whether the main or the risk scenario materialises. It will take many months for the yen as a funding currency to regain investors' confidence if we see the expected increase in the exchange rate in H1. An uptrend for the yen should not be ignored. Particularly not when considering that the preceding trend lasted for about seven years!

Commodities

Seen from the point of view of commodities, the prospects for 2008 seem bright, but this is not the whole truth. A stronger USD and economic and financial hangover will offset continued strong growth in demand in emerging-market countries.

With respect to base metals, we expect that EM countries will, through steep growth in demand, offset slower growth in demand elsewhere. On the supply side, we anticipate that several years of high prices are beginning to trigger higher growth in supply. The growth in demand will, however, be so strong that global stocks stay comfortably below the longterm average. This, combined with continued high production costs will support prices. We believe that part of the weaknesses for 2008 has already been discounted in the present base metal prices, and consequently we expect to see marginally rising prices from the present levels in 2008.

Despite a forecast slowdown in the US economy, we expect to see solid growth in the demand for oil - especially in H2 2008 - when EM countries will be the main driving force. The oil market will in other words remain tight in 2008 with relatively low OECD stocks, bottlenecks within refinery, geopolitical risks and moderate surplus capacity in OPEC. This does, however, not change the fact that the price will, due to the slowdown in economic growth and the strengthening of the USD, decline in H1 and increase again subsequently.

In H1 2008, several factors will support a rising gold price, including the status of gold as a safe haven during turbulent periods of time in the financial markets as well as insurance again rising inflation. On the other hand, a solid strengthening of USD cannot help having an impact on gold due to the usually strong inverse correlation between the development of USD and the development of gold. Therefore, we do not expect that the precious metal can repeat recent years' success with returns at the high end of 20 per cent.

High wheat prices in 2007 are expected to result in higher production in 2008. On this basis, among other things, we expect to see declining prices at six months' term when the US harvest will come in. Historically low global wheat stocks and a strong demand at the export markets point to rising wheat prices in H2. An increase in the sowing of wheat indicates that corn and soy beans must battle for the remaining area. This combined with strong global demand from e.g. China and the ethanol industry will result in a decline in stocks and an increase in prices.

Equities

What is crucial for the development of equities is not whether the US economy will slide into recession or not. If investors anticipate that recession will set in, the effect will be the same. Consequently, earnings expectations will fall to “almost” recession level. This is exactly what investors have experienced in recent months.

Earnings expectations for 2008 are in our view too high and must therefore be downgraded in the US as well as in Europe. But should the economy slide into recession, lower Fed-funds rates will support the equity markets.

Basically, the fundamental conditions for equities are still reasonable with respect to economic indicators, global economic trends and the fact that investors are not overinvested in equities.

We expect that the equity markets will increase somewhat from the current level. The majority of this year's equity returns will materialise in H2 when the economy will report better growth rates and when investor jitters flag off.

In general, we still expect that 2008 will be a normal year with respect to returns (5-10%), corresponding to the long-term trend in corporate earnings.

We prefer US equities to European equities due to expectations of stronger monetary-policy flexibility on behalf of the Fed compared with the ECB, and also because investors are still overweight in European equities. A factor which can be an additional problem when the trend in corporate earnings may disappoint in 2008.

Danish shares plunged over the past three months. The decline was also somewhat sharper than in other equity markets. Although equities now no longer seem to be more expensive compared with other countries, earnings key figures in cyclical equity markets, such as the Danish market, are undoubtedly somewhat behind. Or in other words - equities are on the decline now - whereas earnings will be on the decline in the future. We believe that H1 will end slightly better for equities than it seems just now. But still with a negative development for H1 as a whole. For H2, we anticipate a somewhat better development to the effect that Danish equities will end the year in moderately positive territory.

Emerging markets

In general, we predict that 2008 will be yet another year characterised by good returns in EM. Given our expectations that the US will avoid recession, and that global economic growth will be at the high end, boosted primarily by strong growth in EM, we anticipate that risk tolerance will stage a comeback in the course of H2. For the full year, we expect to see a return in local currency of 10% at index level whereas the return in core currency is expected to come out around 5-6% in USD terms.

Although we anticipate good returns, it is worthy of note that we will presumably be in another regime than in the period 2003-2006, which was characterised by sharp global economic growth, relatively relaxed monetary policy, low inflation, low financial volatility, ample liquidity and resultant highly risktolerant investors. The fundamental background has hence grown much more challenging - and there is a stronger need to be selective.

We anticipate that a volatile H1 will be replaced by a more positive H2. The financial crisis has not yet fully let go of the financial markets, and in H1 a slowdown in economic growth (especially in the Western world) will go hand in hand with high inflation in a number of EM countries. This may rekindle jitters and put several EM central banks in a difficult situation. In general, we also expect that the central banks of a string of EM countries will not be quite as responsive as the markets would have liked. Still, we anticipate volatility rather than negative return, due, among other things, to the resistance shown by EM assets in the recent turbulent period of time.

We believe that H2 will be more positive, due for instance to a clarification of the global economic growth situation in the US and in the euro zone.

Corporate bonds

In recent years the appetite for risk has been quite high, fuelled by the falling default rate (currently below 1%) and strong growth rates with respect to earnings and economic growth. 2008 will be quite an interesting year for the credit market as to a very high degree it will be of importance to act on two important theorems ensuing directly from the characteristics of the asset class. Buy long-term bonds when the price has fallen to a level when, as a creditor, you can expect to get your dividend if the company goes bankrupt. Buy short-term bonds if the company has high liquidity/access to liquidity.

However, generally it is to be expected that some of the themes of the previous years such as LBOs and structured bonds issues will die out.

At the beginning of 2008 we are facing a situation where the crisis in the financial sector has not yet been solved. We do not foresee that these problems will disappear right away. Banks are playing a most crucial role in respect of the default rate. They are the ones that take action when a company gets into trouble.

The first half of the year will be characterised by these problems - particularly the first quarter. Also, the first half of the year will be affected by the situation that a large number of companies in the US or companies with exposure to the US will have problems generating earnings growth. The credit market will focus very much on the ability to accept and handle this new market situation. Thus, the credit market will focus more on consolidation than on growth. A positive theme will be the decline in new issues relative to recent years. This will support the credit market in Q2. On the whole, we expect that H1 will start off on a bad note but end on a good one.

The positive trends will continue into H2, yet at some point the market may again be up against some adversity. We expect that the default rate will begin to go up - although we do not expect any marked increase. Also, we should bear in mind that it may create noise in the market, especially if any major name defaults. That is not unlikely, particularly not within construction in the US. This may result in volatility over the past quarter of the year.

For the year as a whole, we expect yields of about 5-7.5% for global high yield, which will primarily be fuelled by the development in the two middle quarters of the year. The reason for this is the expectation that the spread will widen by up to 75 bp over the year, which will result in a loss of up to 3.5%, while the coupon income will bring the total yield up to about 5- 7.5% (the basis for the scenario ML HY index). The yield will probably be more or less evenly distributed between H1 and H2.

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.