• Wake-up call. The days of rising global oil production are almost over. The warning from the International Energy Agency (IEA) of an energy crunch by 2012 was a wake-up call for even the dyed-in-the-wool optimists (pages 7-9).
  • Upward trend. We were not surprised by the IEA report as we always based our medium-term forecasts on the argument that supply bottlenecks will drive the primary oil price trend higher, i.e. a development beyond cyclical and seasonal fluctuations.
  • Levels. Over the short term, the oil price could once again test the USD 70 per barrel mark, if there are no major hurricanes this season and speculators, therefore, scale back their extreme long positions (cf. chart below). However, the primary trend will be upward.
  • Strain. Rising oil prices are a drag on the global economy. However, improving energy efficiency as well as the general tightening bias of central banks should keep growth and inflation risks in check.
  • Germany. German energy spending should decline this year, despite rising energy prices, supporting consumption. But the sole reason for this is the past mild winter (page 10-12).

Further topics:

  • US growth: Weaker H2, but not really weak (pages 2 & 4).
  • Italy: Government waters down pension reform (page 13).
  • Japan: Upper House election – Litmus test for Shinzo Abe (p. 15).
  • Data outlook: Eurozone inflation to remain below 2%; Bank of England to leave repo rate unchanged; solid US labor market (p. 16).   Market outlook: Euro and bonds to remain in demand (p. 24).

US: Down but not Out

Subprimemania dominates headlines and market sentiment, and has cast a dense cloud of concern over prospects for both financial markets and the real economy. On the markets side, financing seems to be drying up, with investors sitting on the sidelines and unwilling to provide funding even for long-planned deals. As we go to press, the turmoil has spread from credit markets, triggering sharp falls in equity markets and a marked widening of spreads on risky assets. (cf. chart). There is a clear element of panic in the current price action, and it is very hard to predict how much further the sell-off will go.

The abruptness of the movement is, in our view, somewhat at odds with the fact that the economy is still in rude health, both globally and in the US. Concerns that a further deterioration in the housing market would finally take a toll on the US consumer and drag GDP growth down seemed to have been priced out of the market in early June, when investors finally came around to the Fed’s sanguine outlook and real bond yields rose to price a stronger outlook for US growth (cf. chart next column). The fact that the most recent woes in the subprime/CDO universe have brought these concerns back with a vengeance says a lot about the underlying uncertainty and volatility of market sentiment.

We certainly do not want to underplay the importance of current developments in the subprime market. We realize full well that new waves of resets in adjustable rate mortgages will hit the subprime market during the coming six to nine months, triggering more foreclosures and causing more troubles in the CDO market. However, we do not believe that this will by itself have a devastating impact on the real economy. On the supply side, the worst impact of the housing deceleration should have already been felt, and we expect that the drag of residential construction on growth will have almost completely faded out by the end of this year or early next year. On the demand side, as housing prices have cooled down for some time, we have already seen the weakening stimulus of the equity-extraction channel. Will foreclosures have a much more dramatic impact? A number of households will be suddenly hit by a significant rise in mortgage payments, and will find themselves unable to meet them. As the house price appreciation that they were hoping for at the time of the house purchase did not materialize, they will probably not be able to refinance the existing mortgage, and will have to accept the prospect of foreclosure and seeking rental accommodation. This will no doubt be an extremely painful process at a personal level, but should not necessarily result in a sudden reduction in current disposable income.

The labor market here plays a key role, in our view. With the unemployment rate still at a very low 4½% (cf. chart next page), most US consumers should be able to cope with the ongoing downturn in the housing sector. In fact, it is interesting to note that during the last several months mortgage foreclosures have consistently been higher in those geographical areas where the local economic conditions have deteriorated more seriously, resulting in higher local unemployment. This seems to confirm that the most important factor by far is whether or not people have a job, rather than whether or not they have been able to benefit from substantial house price appreciation. With the labor market showing a remarkable resilience, therefore, we believe the downside risk to consumption should not be exaggerated.

We should be clear here: we are not expecting a permanent boom in consumption. On the contrary, we believe that rates of consumption growth above 4% as we have witnessed in the last quarter of last year and the first quarter of this year are unlikely to be sustained, and we are forecasting a slowdown in consumption growth to just above 2% during Q2 2007 through Q1 2008 (cf. Research Note by Roger Kubarych). The drag from residential construction gradually fading, a moderate pick up in fixed investment and some support to net exports coming from a more competitive USD and buoyant foreign demand should be more than enough to sustain GDP growth at about 2% during H2 this year, after the widely expected strong rebound in Q2 (data to be released later today).

Bottomline: The US economy is down but not out—not yet. The subprime sector by itself would not be enough to trigger a recession. However, the latest market movement clearly highlights the risk of a serious credit crunch that might substantially alter the scenario. Should credit dry up completely and for a prolonged period, then even the sizable cash reserves that firms are currently holding would not be enough to support investment, especially in a situation of rapidly worsening sentiment. The credit crunch could then have a significant impact on the real economy, and not only in the US. We still see this as a risk scenario, not a baseline. But after the market movements of the last couple of days, the probability of this risk scenario has clearly risen, and developments over the course of next week might prove crucial.