General

We have increased our global growth forecasts since we wrote last; we expect the global economy to grow by 4.5% and 4.3% 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. The balance of risk is more reasonably poised despite some downside worries in the US. We still expect world inflation to be little changed from the current 1.7% level. The core inflation rate is also expected to be broadly unchanged, rising by about 1.9% during 2007 and the same again in 2008. There is some danger that the next significant upswing in global economic activity in 2009/10 will necessitate a marked tightening of monetary policy, leading to de-leveraging and an unraveling of appetite for risk.

United States

Our central view is that US growth will stay fairly muted throughout 2007 as the correction in the housing market continues and as consumer spending slows after its buoyant start to the year. Indeed, we have modestly reduced our forecast of GDP growth this year to 2.0% in the light of higher gasoline prices and an unexpectedly weak overall growth figure for Q1. Nonetheless, we see some upturn developing towards year-end as the housing and inventory corrections end and as the pressures on consumers ease. As a result we continue to forecast 2.6% GDP growth in 2008 on a year average basis, with quarterly growth back up above trend in the second half of next year. But with below trend growth in the near term and some easing of the labour market, we expect to see core inflation measures to fall in the second half of this year. We continue to believe the next move in the Fed Funds rate will eventually be down and project a fall to 4.75% on a one year view.

United Kingdom

The UK economy still appears to be robust, with the 2.8% growth 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 some 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 2.5% growth rate. Headline inflation should fall back sharply over the next six to twelve months, dipping below the 2% target in early 2008. However the Monetary Policy Committee (MPC) is likely to do little in the near term to dispel the idea of another rate hike after May’s move to 5.5%. Our central view is that a move above 5.5% will not be necessary. Indeed, we still see the prospect of a fall back to 5.0%-5.25% by mid-2008. However, the short term risks are clearly to the upside.

Continental Europe

The Euro area economy is still expanding at an above-trend rate, driven by strong global demand and a favourable investment climate. Moreover, a significant improvement in the labour market over the last year should underpin consumer spending in coming months. However, we expect momentum to ebb slightly in the second half of this year in response to tighter monetary conditions and softer global activity. The dampening impact of higher interest rates is already starting to have an impact on the housing market most notably in France and Spain. In recognition of stronger-than-expected activity recently, this year’s growth forecast has been raised from 2.3% to 2.5% but we continue to expect growth to moderate to 2.0% in 2008. Inflation should remain around its current rate of just below 2% for much of the next two years. Against a backdrop of above-trend growth the ECB is certain to raise rates to 4% in June, with 4.25% likely in the second half of this year. But this should be the peak in rates in the current cycle.

Japan

The Japanese economy continues to move ahead steadily. Growth over the last few years has been driven primarily by private capital spending and by exports, both of which are now showing signs of fading. This leaves the outlook heavily dependent on the prospects for consumer spending. But despite a projected acceleration of consumer spending, we project that overall GDP growth will slow from 2.2% in both 2006 and 2007 to 1.8% in 2008. Headline CPI inflation has fallen from a recent peak of 0.9% last August back just into negative territory in February and March, with some further sub-zero figures likely between now and the autumn. However, underlying inflationary pressures should now be gently upwards if excess capacity has been eliminated and a small positive ‘output gap’ has emerged, as the Bank of Japan assumes. If we are correct in our forecast that CPI inflation in 2008 will average 1.0% then there will be a case for accelerating the pace of interest rate hikes next year.

Pacific

Developed Asian equity markets maintained their positive start to the year and in sterling terms are up 10.9% at the time of writing. In the current quarter Australia was up 4.0%, Singapore up 2.3%, New Zealand up 4.1% and Hong Kong up 0.3%. The markets have clearly 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 that had effectively doubled in the previous 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.

Bonds

The Federal Reserve has now left US interest rates unchanged for the eighth consecutive time. Although inflation did rebound somewhat in January it has since fallen back steadily. While the Fed remains confident on growth and the economy, it continues to voice concerns over wage inflation in a tight labour market. UK inflation spiked to 3.1% in January and the Bank of England responded by raising rates to 5.5% in May. More recently inflation has fallen back to 2.8% and is expected to continue to fall over the remainder of the year but the risk is that the Bank may see the need to raise rates again to 5.75% but this is likely to be the peak in the current cycle. As expected the ECB raised rates to 3.75% in March and we forecast another rate hike to 4% in June and another to 4.25% in the latter half of the year. 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%.

Currencies

The US dollar remains volatile and in mid-April it traded at over $2 to the pound for the first time since 1992. Whilst there has been some dollar strength since, it was still weaker by 1.4% against the pound and by 2.3% versus the euro for the quarter. 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, but for now US growth and the all important consumer confidence remains intact. We expect the dollar to remain volatile versus the euro and pound but believe it is likely to weaken more 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 and will almost certainly raise rates again to 4% in June.