General

After growing by just over 5% in 2006, we expect the global economy to grow by 4.7% and 4.4% respectively over the next two years. Focusing on developed nations (the average of the US, UK, Europe and Japan) we forecast moderately below trend growth of 2.3% 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. On the basis that oil prices average $70 a barrel in the medium term (revised up from $65) world inflation is expected to be little changed from the current 1.8% level. Our forecasts are broadly in line with consensus in 2007, with the exception of Japan where inflation is expected to surprise in 2008. The next significant upswing in global economic activity in 2009/10 may necessitate a marked tightening of monetary policy, leading to de-leveraging and an unravelling of risk appetite.

United States

The US economy is bouncing back after a period of weakness. That soft spell reflected an inventory correction, a pause in capital spending and the ongoing weakness of residential investment. Our central view is that growth will remain a little below trend for several more quarters as consumer spending struggles in the face of high energy prices and the weak housing market; and that it will be mid-2008 before the economy starts growing at a pace consistently above trend. Consequently we continue to see GDP growth of 2.0% this year, 2.6% in 2008 and project robust growth of 3.3% for 2009. Core measures of inflation appear to be edging lower in response to the sub-trend growth of recent quarters. Headline CPI inflation may now ease only a little this year to 2.9% on average, followed by 2.5% in 2008 and 2.4% in 2009. The most likely outlook now is that the Fed Funds rate will be held at 5.25% for a lengthy period, with the possibility of an upward move in the latter part of 2008.

United Kingdom

The UK economy still appears to be robust, with the 2.9% growth of GDP over the year to Q1 2007 driven by business investment and, to a lesser extent, consumer spending and housing investment. However, there are signs that higher short term interest rates and relatively strong sterling are starting to have an adverse effect. We do not expect a major slowing; indeed, on a year average basis, GDP growth this year may be little different from 2006’s 2.8%. For 2008 we do expect some slowdown to a 2.3% growth rate but we project a re-acceleration to 2.6% in 2009. Headline inflation should continue to fall over the next six to twelve months, dipping below the 2% target in early 2008. However, the MPC remains concerned about the medium-term upside risks to inflation. A final increase in interest rates to 5.75% now looks inevitable, although we see scope for an easing back to 5.25%-5.5% during 2008.

Continental Europe

The Euro area economy has continued to grow at an above-trend rate, shrugging off the headwinds from the German VAT hike and the slowdown in the United States. Strong export demand, a rebound in business investment and a turnaround in the German construction sector have been the drivers of growth, while falling unemployment points to a greater contribution from consumer spending in the future. However, we continue to expect activity to moderate slightly over the next year as the impact of higher interest rates and the strong currency begins to be felt. There are already signs that higher interest rates are beginning to impact on the housing market. After growing an above-trend rate of 2.8% in 2006, GDP growth is forecast to remain robust at 2.6% in 2007, before slowing to 2.1% in 2008 and 2009. Headline inflation is currently running on target but is likely to move back above 2% in the second half of this year. In this environment, the ECB is likely to continuing hiking rates, possibly to 4.5% by the end of the year.

Japan

The Japanese economy continues to move ahead at a solid pace. We have raised our forecast for growth this year to 2.6% which is above the 2.25% average of the three previous years. However there are some negatives in prospect. Capital spending is likely to slow in response to the deceleration of profits that is already evident and net exports may make a less positive contribution to growth next year. On the positive side, we expect that the fairly tight labour market will feed through to stronger wage growth and some further pick up in consumer spending. Overall, we expect that growth in 2008 and 2009 will run broadly in line with the 1.75%-2% that we see as sustainable in the medium term. A number of indicators suggest that deflation is ending and we expect that the annual change in the CPI will move up from zero this year to 1.0% in 2008 and 1.2% in 2009. With this background, we see a gradual upward move in the target overnight rate to 1.5%-1.75% by the end of 2008.

Pacific

Developed Asian equity markets maintained their positive start to the year and in sterling terms are up 8.9% at the time of writing. In the current quarter Australia was up almost 2.7%, Singapore up 0.6%, New Zealand up 4.0% and Hong Kong up 3.0% in May alone. The markets have clearly regained their poise despite concerns over the slowdown in the US and ongoing concerns over China’s continued strength. Valuations are generally fair and we see little prospect for a broader re-rating across the markets. We remain positive on the outlook for the region and believe that it will continue to benefit from strong growth in China.

Bonds

We have made some changes to our interest rate forecasts since last month reflecting the resilience of global growth. We now expect US rates to remain stable at 5.25% over the next 12 months. In the UK, we think interest rates will rise by another 25 basis points to 5.75% where they will remain for some time, although a cut is possible by early summer next year. In the Eurozone, we expect rates to rise to 4.5% and to remain unchanged thereafter, and we expect the Bank of Japan to steadily tighten monetary policy to 1.25% in 12 months’ time. Given the lack of a decisive downswing in global economic activity and longer-term upside inflation risks we now expect the following 10-year government bond yields: In the US we expect yields to rise modestly to 5.4%, although we may see a short-term yield decline from oversold levels. In Europe, we think yields will end up unchanged at 4.6%. In the UK we forecast a modest decline in yields to 5.4%.

Currencies

The US dollar remains volatile and more recently it has again traded at over $2 to the pound for the first time since mid-April this year. Over the quarter to date the dollar has weakened by 1.1% against the pound and by 0.7% versus the euro. We now anticipate that The Federal Reserve will maintain rates at their current level over the next twelve months. Clearly with interest rate differentials moving against the dollar it will likely keep the dollar under pressure despite the sharp fall in the US Current Account deficit and a rebounding economy. We continue to expect the dollar is likely to weaken more against Pacific/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 4.0% in June. It is widely expected to raise rates to 4.25% during the latter half of the summer before moving to 4.5% before year end.