General

There has been only a small change to our overall economic view since last month, reflecting a downgrade to our forecasts for the euro area. Focusing on developed nations (the average of the US, UK, Continental Europe and Japan), we forecast a slowing of growth from 2.4% in 2007 to 1.6% this year, followed by a modest acceleration to 2.0% in 2009. We place a 60% probability on our above forecast, 30% on a near-term recession and 10% on a short-term re-acceleration of activity. Our forecast for developed nations’ growth is now slightly above the consensus over the next 12 months. Upward pressure on “world” headline inflation may persist for a few more months reflecting energy, food and other commodity prices but the numbers should then fall back due to favourable base effects (rising energy prices a year before). Our inflation forecasts are generally a little above consensus for 2008 but broadly in line for 2009.

United States

The US economy is now slowing quite sharply and our central view is that it is set for several quarters of low growth, as a result of the weakness in the housing market and the broader impact of reduced credit availability. We expect that the economy will eventually start to recover in response to lower interest rates and tax incentives. On this basis, our forecast is that year-average GDP growth will slow from a 2.2% pace in 2007 to 1.7% this year. However the risks are weighted to the downside and we would put as much as a 50% probability on a weaker scenario in which consumers become markedly more cautious, the decline in residential investment is more persistent and business investment turns down. Headline CPI inflation may run at around 4% over the next few months due to high food and energy prices, but it should fall back. On our central view, the Fed Funds rate will be cut to 2.5% in the near term and will hold at that level for a couple of quarters.

United Kingdom

There is now clear evidence that the economy is starting to slow. Our central case is that a weaker housing market and slower growth of financial services will curb the economy, reducing GDP growth from a buoyant 3.1% this year to sub-trend rates of 1.9% in both 2008 and 2009. This is not a particularly sharp slowdown; indeed, by the latter part of 2009 we expect to see the start of a pick-up towards the trend pace of 2.5%. However, a more serious setback is possible if consumers become markedly more cautious. CPI inflation is likely to run a little above the 2% target over the next two years, with year-average figures of 2.2% in 2008 and 2009. Following the February cut in official interest rates to 5.25%, we expect a further cut to 5% by mid-2008. Two additional cuts, to 4.5% by end-year are likely provided that inflation expectations fall back from currently elevated levels.

Continental Europe

Euro area GDP growth is forecast to slow sharply from 2.6% in 2007 to a clearly below trend rate of growth of 1.5% in 2008 and 2009. Activity indicators are already signalling a significant loss of momentum around the turn of the year. This slowdown is the result of tighter financial conditions brought about by past increases in policy rates, the strong euro and the recent increase in risk premiums. Deteriorating external economic conditions are also acting as a significant headwind to activity. Areas of the economy that have been strongest, such as investment, particularly residential investment, are expected to slow further over the next year. We no longer expect consumer spending to provide an offset, given the dampening impact of higher prices on real income growth and upward pressure on the household saving rate from greater uncertainty. There remains a significant risk that follow on effects continue to push inflation higher but the most likely outcome is that weak activity causes underlying inflationary pressures to diminish. Headline inflation is forecast to average 2.7% in 2008.

Japan

Japan’s economy appears to be weak at present but should show some upturn in the months ahead, as housing activity recovers from its recent artificially depressed level. However, business investment is likely to slow further in response to weaker profits growth. Net trade has been a significant contributor to growth over the last two years but the effect is likely to fade due to a stronger yen and slower growth of global activity. Our forecast is that GDP growth will slow to a sub-trend 1.2% in 2008, before recovering to 1.7% in 2009. Our inflation forecasts assume that deflation is gradually being eliminated in response to earlier strong economic activity. As a result, we expect CPI inflation to average a positive 0.8% in both 2008 and 2009. Nonetheless, the pace of normalisation of interest rates is likely to be slow, and we expect the official overnight rate to rise from the current 0.5% to only 0.75% by the end of 2008.

Pacific

Developed Asian markets did not escape the start of 2008 unscathed - all markets fell sharply, with New Zealand and Australia performing slightly better than Hong Kong and Singapore. Australia's central bank raised its benchmark interest rate by a quarter point to an 11-year high of 7% on 5 February saying a “significant slowing in demand” is needed to cool the fastest inflation since 1991. Australia becomes the first developed nation to raise borrowing costs after Federal Reserve Chairman Ben S. Bernanke cut the US rate recently in the fastest easing of monetary policy since 1990. Economic data from across the Asian markets continue to confirm our belief that growth (in selective countries) remains relatively strong versus the global average, particularly in India and China. China's central bank raised the reserve requirement ratio for banks by a further 50 basis points to 15%. China announced price controls on basic food items in order to keep a lid on inflation, at the same time they also raised export taxes on products such as finished steel.

Bonds

Our government bond yield forecasts have not been changed and point to higher yields in 12 months time. In the US, we think ten-year Treasuries will trade at 4.85% which implies a 100 basis point rise in yield from the current level. In the UK, Eurozone and Japan, 10-year yields are expected to rise by between 35 and 45 basis points to trade at 4.85%, 4.45% and 1.95% respectively. As a result, bond market return forecasts remain relatively low on a 12-month investment horizon. We are of the opinion that bonds are over priced and that current yields remain unattractive, and as a result we are underweight across all strategies. Yields are likely to remain volatile in the short run, but a sustained rise is expected in the latter half of 2008. Our yield forecasts appear to be modestly above consensus in the US, UK and Eurozone, but just below in the case of Japan.

Currencies

The US dollar was the weakest of the major currencies in January, undermined by a 0.75% emergency interest rate cut followed by a further easing of 0.25%. Meanwhile, the low yielding Yen and Swiss Franc were at the stronger end of the spectrum as investors looked for safe havens amid the turbulence in equity markets. Looking ahead, we expect the US dollar to be the strongest of the major currencies over the next 12 months as US interest rates surprise on the upside compared to market expectations. Conversely, we continue to expect the overvalued euro to be the weakest of the major currencies.