Australia | Sep 08 2006
By Chris Shaw
In the past couple of days the US market has been hit by renewed fears interest rates may need to be raised further, a reversal of the position of recent weeks where the indications had been the next move on rates would be downward. This uncertainty as to the economic outlook is proving difficult for investors, increasing volatility in markets and preventing the emergence of any clear trend.
With a view to understanding the bigger picture Danske Bank has updated on what it sees as the most likely scenario for the global economy, painting a picture that should prove supportive for investors if things pan out as the bank imagines.
The bank’s overriding view is the fears of investors the current slowing in industrial indicators and the weakness in the US housing market will result in a slowdown in global financial markets are unfounded, as while the trend will continue down in coming months there will be a bottoming late this year or early next year before a recovery during 2007.
This view is based on the expectation the housing market in the US will engineer a soft landing and low real interest rates will remain. In the bank’s opinion recent data from the US has been misleading as lower personal and business spending was the result of higher energy prices, a trend it now expects will reverse as oil prices appear to be in a downtrend.
Despite this positive, Danske Bank suggests the US Federal Reserve has not yet finished tightening rates and further tightening over the course of 2007 will result in a headline interest rate of 6%. The moves will be in response to ongoing strength in domestic consumption as well as tightness in both labour and wage markets, which should keep inflation above the target rate of 3%.
This tightening is likely to create far more difficult conditions by late in 2007, so the bank’s expectation is for a more serious downturn in 2008. This suggests the bears may be on the right track, but have their timing wrong in the bank’s view.
For Europe the bank has not changed its view, which is for a long, slow recovery after a prolonged period of weakness. It notes while GDP growth is currently at around 3%, the combination of higher interest rates and a slowing in the global industrial cycle will act as headwinds. As a result, it sees growth returning to trend rates of about 2% in coming quarters.
The recovery in the region has been driven by an increase in investment, which the bank points out is somewhat of a catch-up given years of underinvestment by European corporations. With an improved outlook for the economy as a whole the bank sees investment remaining strong and some increase in wages, though this is not expected to be enough to create substantial inflationary pressures unless the oil price were to move higher.
Even accounting for two further increases in rates by the European Central Bank (ECB), Danske Bank sees the most likely outcome as an acceleration of growth in the latter half of 2007 as the global economy again picks up.
Its views on Asia are also consistent with its previous expectations, as despite weaker data from Japan of late it sees little threat to the ongoing structural recovery, while also discounting the potential for further tightening measures in China to be successful in slowing the economy significantly.
The bank accepts the recent downward revisions in the Japanese CPI (Consumer Price Index) make further rate increases unlikely this year, but it continues to caution the market is underestimating the potential for future rate rises as the Bank of Japan (BoJ) moves to normalise interest rates following the ending of the zero interest rate policy.
It also suggests fears Japan’s recovery will be derailed by a slowing in the US are unfounded as to date it has been strong investment by Japanese corporations that has driven growth, while the low level of unemployment and signs of improvement in wages will see the consumer eventually join the party.
The recent tightening measures in China should have little impact as the bank expects local authorities will find ways to circumvent the new restrictions, so the issue of excess investment will remain. As a result it suggests the market will see further flexibility in the Chinese currency, as this remains the only real way to deal with the issue of excessive capital inflows.
The above outcomes the bank considers most likely, but of course many things could still occur and the reality may prove to be very different. The bank has therefore given both a goldilocks and worst-case outcome and the likely implications of either occurring.
For the goldilocks scenario to unfold would require further falls in the oil price, which in turn would reduce inflationary pressures and produce a rebound in global growth. This improvement in the industrial cycle would spark an increase in demand, while the US housing sector would recover and US consumer confidence would remain high thanks to a continuation of the wealth effect of stronger housing prices. Equity markets would benefit from improving corporate profits and investor sentiment would remain strong.
The flip side is a hard landing in the US housing market, which would see global growth slow sharply as consumption and business confidence levels fall. The US housing slowdown flows through into the Asian and European economies, the slowing in global growth sparking fears of recession. To counter this central banks cut interest rates, but cannot do so fast enough because of ongoing inflationary pressures, meaning equity markets, and particularly those in emerging economies, would move lower.