Current Economic View
End November 2007

General

Despite recent volatility our economic forecasts remain unchanged from last month. Globally, we expect 5% real GDP growth in 2007, 4.5% in 2008 and 4.3% pencilled in for 2009. Focusing on developed nations (the average of the US, UK, Continental Europe and Japan), we forecast moderately below trend growth of 2.3% in 2007, 2.1% in 2008, followed by a modest acceleration to 2.4% in 2009.
We place a 65% probability on our central forecast, 25% on a near-term recession and 15% on a short-term re-acceleration of activity. Our forecast for developed nations’ growth is now broadly in line with the consensus over the next 12 months following investment banks downgrading growth expectations. The recent interest rate cut in the US is a clear indication that central banks remain ready to act to re-liquify the markets in an attempt to prolong the current economic cycle.   

United States

US GDP growth was surprisingly strong in the middle quarters of 2008. However economic activity is expected to slow again for the next few quarters due to high energy prices, continuing problems in the housing market and tighter availability of credit. The most likely outcome is that the economy will grow at a sub-trend pace until the middle part of next year, but will then start to pick up pace again as the direct and indirect drag from housing eases. On that basis, we forecast an acceleration of GDP growth on a year average basis from 2.1% this year to 2.3% in 2008 before a slightly above trend 3.0% in 2009. In the short term a little slack may emerge in the economy with the unemployment rate possibly moving up to 5%-5.25% over the next few quarters, which should help to keep inflation reasonably subdued. We expect another cut in the Fed Funds rate to 4.25% next month with more cuts likely if financial problems persist.

United Kingdom

The UK economy seems to be at a turning point but there is no clear evidence yet that a significant slowdown is actually underway. Our central case is that a weaker housing market and slower growth in financial services will curb the economy, reducing GDP growth from a buoyant 3.0% this year to sub-trend rates of 2.0% in 2008 and 2.1% in 2009. This is not a particularly sharp slowdown and indeed by the latter part of 2009 we expect to see growth moving back up towards the trend pace of around 2.5%-2.75%. However a more serious setback is possible if consumers become markedly more cautious. CPI inflation is likely to run close to the 2% target over the next two years, with domestic economic weakness offsetting some less favourable global influences. This background is consistent with a cut in the official bank rate from 5.75% to 5.25% over the next two or three quarters. A further cut to 5.0% is quite possible if problems in the financial sector persist and credit availability deteriorates significantly.

Continental Europe

Euro area economic activity is decelerating in response to higher interest rates and the strength of the Euro. Recent financial market disruptions have contributed to an additional tightening of monetary conditions, as reflected in higher term rates and tighter bank lending standards. Interest rate sensitive sectors of the economy, such as investment spending and housing, are likely to be most affected by tighter financial conditions, while continuing improvement in the labour market should underpin reasonable growth of consumer spending. Overall, we continue to forecast growth to settle around its trend rate of 2%, albeit the risks are skewed to the downside. At 2.6%, inflation is significantly above the ECB's target and is likely to remain at this elevated level until the spring. Although risks from energy prices are on the upside, the economy is no longer growing above its trend rate. Interest rates are forecast to remain on hold for at least six months but there is a fair chance of a cut in the second half of next year if downside growth risks materialise.

Japan

The Japanese economy rebounded in Q3, despite the adverse impact of tighter building regulations, but looks likely to grow at only a relatively subdued rate over coming quarters. Consumer spending is falling short of earlier hopes, mainly because the tighter labour market has not fed through to stronger wage growth. Exports have been buoyant, benefiting from the competitive yen, but are likely to slow in response to subdued growth in the developed countries and policy tightening in China. Overall we expect GDP growth to come in at 1.8% this year and 1.5% in 2008 before accelerating back to 1.8% in 2009. We continue to project some pick up in inflation, but only to 0.6% on average next year and 0.8% the following year. As a result, 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% only to 1.0% by end-2008.

Pacific

Asian markets remain volatile due to the US subprime contagion which rippled over the global markets. However, despite some concerns that emerging markets may sell off dramatically, the region continues to do well with the MSCI Pacific Rim Ex Japan index up by 7.9% in sterling terms over the quarter having been up by 21% at the end of October with strong contributions from Australia, Singapore and Hong Kong. The Australian economy continues to set a rapid pace, with strong commodity prices continuing to be a firm driver. Interest rates have again been left unchanged in Australia at 6.5%, but the expectation is still that the next
move will be upwards as the central bank looks to contain the risk of the economy overheating. The Australian economy is growing at its fastest pace in three years, with Q2 GDP reported at +4.7% year-on-year. The trade deficit increased, due to higher costs from imports of consumer goods and oil. The growth is forecast to continue despite the general election result in favour of the Labour party.

Bonds

There has been a change to our interest rate forecasts from last month. In the US, we now expect another cut of 25bps next month and expect no further interest rate cuts assuming conditions in financial markets do not materially deteriorate. In the UK, an economy which is more exposed to the financial sector, we think 5.75% will mark the peak in interest rates. We believe that base rates will approach 5% by the end of next year, with cuts taking place sooner rather than later. In the Euro zone, we expect 4% interest rates to remain broadly unchanged over the course of the next year (our previous forecast was for rates to peak at 4.25%). In Japan, we still expect monetary policy to be gradually normalised, which means that the Bank of Japan will edge rates higher to just 1% in 12 months' time. In the UK, Euro zone and Japan, 10-year yields are expected to trade at 5.2%, 4.6% and 1.95% respectively. As a result, bond market returns are relatively low on a 12 month investment horizon.

Currencies

The US dollar continued its decline in October, undermined by falling interest rate expectations and a continued resurgence in more risky, high yielding currencies. The dollar and the yen sat within the bottom half of a broad basket of 72 currencies, with the dollar falling by 2.5% against sterling and by 8.2% against the Euro. High yielding currencies such as the Brazilian real and South African rand were towards the top-end of the spectrum, rising approximately 4% versus the US dollar. However, we do still expect the US dollar to be the strongest of the major currencies over the next 12 months, as economic growth accelerates late next year and interest-rate differentials turn in its favour.