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Friday Notes

Outlook 2008 – Gloom but no Doom

Fri, Nov 30 2007, 15:04 GMT
by HVB Group Global Markets Research

UniCredit Group  |  View company's profile

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● US. A recession is unlikely. However, the economy will have a bumpy landing next year with GDP growth of +1.7% – despite fiscal impulses. To guard against a weaker outcome, the Fed will ease monetary policy over the next two FOMC meetings by lowering the target rate to 4%.

● Eurozone. After almost 3 years of sustained expansion, growth should fall below potential in 2008 with +1.9% (2007: +2.7%). Exports and investment will be hard hit. Since, at the same time, inflation will continue to rise, the ECB should leave the refi rate unchanged next year.

● Yields. The lows for government bond yields are still ahead of us. As financial markets stabilize, long-term interest rates will, however, rise again from the spring on – but only moderately. At the end of 2008, we expect the 10Y T-Note to yield 4.60% and 10Y Bunds 4.35%.

● Currencies. The EUR will continue to soar. By spring 2008, EUR-USD will be trading at 1.55; but afterwards it will then pull back again. On a trade-weighted basis, the USD should, however, continue to lose value. Carry trades will gradually become less attractive next year.

● Further topics:

• – Weekly Comment: The world in 2008 – gloom but no doom.
• – Oil price to defy global growth slowdown.
• – Global economy: Will it slip on oil?
• – Data outlook: European labor markets to remain robust; US manufacturing ISM to slip below the critical 50 level.

The world in 2008: gloom, not doom

The world in 2008 will be a more challenging and uncertain place in terms of both macroeconomic and financial sector developments and investment opportunities. We have just revised our global macroeconomic and financial outlook for the year ahead, and we will lay out in detail our new forecasts in this and the next two issues of our Friday Notes.

We have become somewhat more pessimistic about the outlook for next year, largely because of the second wave of the financial crisis. The problem of uncertainty has returned with a vengeance, tensions on money markets have heightened again, and as we approach the end of the year liquidity has dried up again. This confirms, unfortunately, that it is going to still take several months before the financial market dislocations can be resolved. The spillover onto the real economy through a tightening of credit conditions, therefore, is going to be more serious than we originally expected. To set the stage for investment decisions for the year ahead, therefore, it seems wiser to start with a more conservative macroeconomic outlook. At the same time, it is important to stress that we do not expect a recession or a catastrophic outcome: our scenario is one of gloom, but not one of doom.

In the US, we have scaled down our growth forecasts. After growth of nearly 5% annualized in Q3, we now forecast GDP growth to plummet to half a percentage point in Q4, and just 1% in Q1 and Q2 next year. This forecast reflects a sharp slowdown in consumption as well as investment, and captures the impact of both the tightening of credit conditions and the ongoing contraction in the housing sector. We believe this is a conservative forecast. We have also developed an alternative scenario where the US economy slides into a recession, with zero growth in the current quarter followed by three consecutive quarters of negative growth. This, however, requires a contraction in consumption and investment well beyond what we believe is reasonable to expect. We still do not expect the recession scenario will materialize for a number of reasons: (1) the labor market is still very resilient, and healthy growth of disposable income should support consumption; (2) two years of contraction in the housing sector have not yet caused any significant spillover to the rest of the economy; (3) companies are cash rich, which partially insulates them from credit tightening.

In our scenario, we expect the Fed will cut twice more, starting in December. Until very recently, the Fed had tried to fight market expectations of more rate cuts. This week, however, Vice Chairman Don Kohn conceded that the recent heightening of tensions in financial markets has gone well beyond what the Fed had anticipated at its last meeting a month ago. Risks to growth have increased, and the Fed will need to take out additional insurance. Given our macro framework, which is marginally more pessimistic than the Fed’s, we believe another 50 bp will be sufficient. However, against the background of worsening macro data, the market will keep pricing in a much deeper monetary easing through the end of Q1, and we therefore see room for additional steepening of the yield curve (to 115-120 bp on the 2-10Y) in the coming months. The market will need to see more clarity in the financial sector and a stabilization of macro indicators after the plunge expected in the next few months in order to believe that this will be a soft landing and not a recession. This, we believe, will only happen between the end of Q1 and the beginning of Q2.

Europe will suffer as well. Exports are obviously suffering the strong euro; more importantly, consumer confidence is taking the simultaneous hit of the financial crisis and of rising food and fuel prices. We expect growth of just below 2% in the year ahead. Nevertheless, we expect the ECB will stay on hold for the year, and we expect it will maintain a very hawkish rhetoric in the months ahead, remaining fully focused on the need to control inflationary expectations. Room for additional steepening in the European curve is therefore more limited, even though the pressure coming from the steepening of the US curve will be felt, especially as a further weakening of European growth data might push the markets to price in some chance of monetary policy easing.

Starting in Q2 we expect to see some significant signs of normalization in financial markets. The release of audited accounts for full year 2007 should help bring some clarity on the health of the banking system. Moreover, as the new year starts, we believe some investors will decide to start acquiring assets which look attractive on a fundamental basis. If the normalization does indeed play out, such a strategy would provide a first step towards a good investment performance for the year as a whole. Should market conditions deteriorate again, one would still have the best part of the year ahead to change strategy. This should help bring back some liquidity to asset markets, and in turn alleviate the stress on the banking system. In that scenario, as US macro data begin to improve, we would expect to see the beginning of a pronounced flattening of the yield curve in the US, and to a lesser extent in the eurozone (by about 80 and 30 bp, respectively).

In our baseline scenario, we expect the USD to remain under pressure in the next several months, with EUR-USD moving to 1.55. As the financial situation normalizes and US growth picks up, however, we expect a moderate reversal of this trend, with the cross ending next year at about 1.45. We forecast a moderate acceleration in the appreciation of the yuan, but we do not expect this to be also reflected in a sharp movement of the JPY. Japanese fundamentals remain shaky, and the BoJ will in our view hike at most once more towards the end of next year. The yield difference should therefore remain large enough to prevent a major appreciation of the Japanese currency.

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Published on  Fri, Nov 30 2007, 15:36 GMT

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