Monthly Market Commentary
After growing by just over 5% in 2006, we expect the global economy to grow by a steady 4.5% and 4.2% respectively over the next two years. Focusing on developed nations (the average of the US, UK, Europe and Japan) we forecast moderately below trend 2.2% growth in 2007, and a similar rate of growth in 2008. The aggregate growth rate masks some divergence at the regional level: US growth is expected to accelerate mildly in 2008, in contrast to a further slight moderation in the UK, continental Europe and Japan. The balance of risk is more reasonably balanced despite some downside worries in the US. Our forecast for developed market growth is slightly below consensus this year and modestly above consensus in 2008. On the basis that oil averages $65 in 2007 and 2008, ‘world’ inflation is expected to fall from about 2.4% currently to about 1.7% in 12 months’ time. Despite this gradual slowdown we still forecast a global ‘soft landing’ scenario, in the US economy in particular despite the recent concerns over sub-prime mortgages.
US growth is set to remain fairly muted for much of this year. Business investment has already started to slow somewhat from the 6%-7% pace of the last three years. The recent woes in the sub-prime mortgage market suggest that weakness in the housing market has further to run but that the worst may soon be over, which should not adversely affect consumer spending. Residential investment is likely to contract further, albeit not at the dramatic pace seen in the second half of last year. While we do not see a fall into recession, a significant re-acceleration of growth may be delayed until early 2008. In annual terms, we see GDP slowing from last year’s 3.3% to 2.3% this year before picking up to 2.6% in 2008. With growth below trend and evidence of some easing of the labour market, we expect that core inflation measures will fall a little over the next few quarters. We retain the view that the next move in the Fed Funds rate is likely to be down from 5.25% to possibly 5.0%-4.75% by end-year.
The UK economy is still very robust, driven by business investment and to a lesser extent consumer spending. Nonetheless there are some signs that the housing market is starting to respond to higher interest rates, and exports may slow in lagged response to the strengthening of sterling over the last year. Overall we forecast a modest slowing of growth over the remaining quarters of this year. On a year average basis, however, we now expect that GDP growth in 2007 will match the 2.8% recorded in 2006, before easing to 2.5% next year. We continue to expect a sharp fall back in CPI inflation from April onwards: with the prospect of cuts in heating fuel charges, the annual rate should dip to 1½%-1¾% for a period around year-end. But in the immediate future, the Bank of England Monetary Policy Committee (MPC) will remain concerned about the upside risks to the medium-term inflation outlook.
The Euro area economy remains in good shape with investment and exports still making a strong contribution to growth, and a solid recovery in the labour market. Over the next two years, household incomes should benefit from decent employment growth, lower energy prices and a slight pick-up in compensation. As a result, consumer spending should grow by around 2% in 2007 and 2008, compared with an average growth rate of 1.3% over the last five years. However, overall growth is still expected to slow from 2.8% in 2006 to 2.3% this year and 2.0% in 2008 as exports and investment slow in response to weaker global demand and higher Euro area interest rates. Lower energy price inflation should cause headline inflation to fall from 2.2% last year to 1.8% in 2007, but underlying price pressures remain acute and core inflation is moving gradually higher. In this environment the ECB is likely to raise interest rates to 4% in June and possibly once more to 4.25% in the second half of the year.
The Japanese economy is moving ahead at a solid rate. Growth over the last couple of years has been driven primarily by private capital spending and by exports. There sources of growth are likely to moderate over the next two years but there are signs that consumer spending is starting to pick up. Overall, we expect that GDP growth will be 2.2% this year but the pace will fall back to 1.8% in 2008. Headline CPI has fallen back from a recent peak of 0.9% last August to -0.2% this February, with further negative figures likely between now and autumn. However, this mainly reflects swings in food and energy prices. Underlying inflation trends should now be rising gently, if excess capacity has been eliminated and a small positive ‘output gap’ has emerged, as the Bank of Japan assume. The next hike in interest rates may be delayed until Q4 but we expect a more regular series of increases during 2008.
Developed Asian equity markets maintained their positive start to the year and in sterling terms are up 10.58% at the time of writing. In the current quarter Australia was up 5.0%, Singapore up 5.5%, New Zealand up 2.3% and Hong Kong up 1.2%. The markets have regained their poise after the sell-off at the end of February when China sparked a global sell-off as it attempted to rein in over-heated local stock exchanges which had effectively doubled in the last 12 months. There was talk at one stage that the Chinese authorities were contemplating introducing a capital gains tax to stem equity speculation. This caused locals to sell shares sending the Shanghai ‘A’ index down 9.6% in a day. Although one of the smallest indices in the world in terms of market capitalisation the effect was worldwide as investors believed that China was commencing a period of slowdown from its rapid pace of recent years. Markets are now once again refocused on fundamentals rather than what turned out to be rumour only.
The Federal Reserve has now left US interest rates unchanged for the seventh consecutive month due in part to a sharp fall in inflation, although inflation did rebound somewhat in January it abated in February, March & April. While the Fed remains confident on growth and the economy, it continued to voice concerns over wage inflation in a tight labour market, while the state of the US housing market may precipitate rate cuts in the near future. UK inflation recently spiked to 3.1% and it is likely that there will be another rate rise in May to 5.5%. As global economic activity slows it is likely that any further rise in UK base rates will be reversed by year end. As expected the ECB raised rates to 3.75% in March and we forecast one more rate hike to 4% in June. On a 12-month view we forecast 10-year yields as follows: US at 4.85%, UK at 4.85%, Eurozone at 4.1% and Japan at 1.9%.
The US dollar has been very volatile over the last quarter having weakened by 1.7% against the pound and by 4.3% versus the Euro. During the quarter the continued strength of the UK economy and the subsequent interest rate rises had seen the dollar trade intraday at its lowest level versus the pound for 26 years. The Federal Reserve is expected to maintain rates at their current level until at least mid-year before having to cut rates should growth slow more quickly than anticipated. Sterling had gained due to the resilience of the UK economy and the recent spike in inflation but the Bank of England believes the lag effect of the rate rises will take effect in the coming months. We expect the dollar to remain volatile versus the euro and pound but believe it will weaken against the yen and other Asian currencies over the next 12 months. The European Central Bank remains focused on domestic demand and growth, whilst keeping a close eye on inflation and as expected it raised rates to 3.75% in March.