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Households suffering from inflation

Fri, May 16 2008, 12:09 GMT
by HVB Group Global Markets Research

HVB Group

• Problem. The pressure on US consumers has intensified further. Falling house prices, tighter lending standards and the weakening labor market are a strain. But households say the biggest problem is the high level of inflation. Only due to the tax rebate stimulus package is a temporary recovery in the second half of the year likely, since there are at the moment no signs of an improvement in fundamentals (page 4).

• Pressure. Inflation is also eroding household purchasing power in the eurozone. Fueled by the unexpectedly strong surge in commodity prices, inflationary pressure will remain very high in the short term. Assuming persistently high commodity prices, record-high selling price expectations in the retail sector suggest that there will be no tangible relief until the end of this year (page 8).

• Weakness. Particularly in Italy, inflation and the strong EUR are amplifying the weakness of the economy as a whole. After an anticipated slight technical recovery at the beginning of the year, GDP should at best stagnate in the coming quarters. With meager annual growth of 0.4%, Italy should therefore bring up the rear again this year in the eurozone. The prospects for next year are also bleak (page 11).

• Further topics:
  
  – Weekly Comment: The slowdown is still coming! (page 2).
  
  – Data outlook: EMU business climate surveys point south; US housing market correction continues (page 13).
  
  – Market outlook: Pressure on money markets persists; Trend reversal in EUR-USD not too far off (page 22).

The slowdown is still coming!

The latest set of eurozone GDP data looks like a resounding confirmation of the resilience of the single currency area. Q1 real GDP growth came in at 0.7%, above trend and above consensus expectations of 0.5%. A stunning German performance (+1.5% q-o-q) was accompanied by better-thanexpected results in France (+0.7%) and Austria. True, German growth was boosted by an abnormal surge in construction activity and by a bounce in inventories, which suggest some "payback" is in store for Q2, but even so, it is hard to detect any sign of crisis in these growth figures. The data also confirm the decoupling between the stronger and the weaker countries within the eurozone: Portuguese GDP contracted by 0.2% q-o-q, and Italy’s figure will likely disappoint expectations. On the face of it, these data certainly support the case made by the ECB so far: growth remains robust, and with inflation above 3% and seemingly unstoppable commodity prices, the focus should remain on avoiding second round effects on inflation.

Equally surprising were the eurozone inflation data: the final reading for April was 3.3%, same as the preliminary one, and a nice decline from the March peak of 3.6%. Headline inflation, however, still suffers from a fair degree of base-effects volatility, and we expect the HICP will rebound to about 3.5% in May and stay above 3% for several more months. What was really surprising, however, was the decline in core inflation to 1.6% from 2.0% in the previous month and against consensus expectations of 2.0%. Second round effects? What second round effects? Several factors are probably at work here. First, the hawkish stance of the ECB has contributed to anchoring inflation expectations and encouraging discipline by wage and price setters so far. Second, some of the disinflationary pressures of globalization might still be helping to limit rises in wages and goods prices. Third, there might be an underlying slowdown in the economy which has been more than offset by one-off factors in Q1, but which is already playing a role in cooling core price pressures. We still believe the third factor will play an increasingly important role in the coming quarters, when the eurozone economy will decelerate to a pace below potential growth.

It would be tempting to take the latest eurozone growth data as evidence of a strong form of decoupling, whereby Europe maintains a very robust pace of expansion thanks to its own structural strengths and lack of major imbalances, and thanks to the resilience of most emerging markets. Tempting, but this would mean forgetting that there has been very little to decouple from, so far: remember that Q1 US GDP growth clocked in at a surprisingly healthy 0.6%, defying early expectations of a contraction in real terms. So even though the US labor market has shown clear signs of weakening which comes on top of a still deteriorating real estate sector, overall growth performance does not seem to have been significantly affected yet, giving us the seeming paradox of quite respectable Q1 growth just as almost everyone seems to agree that the US economy is in a recession. This might all seem a bit puzzling: the financial crisis is now ten months old; banks have written off about USD 350 bn already, several segments of financial markets remain heavily dislocated, and yet there is no sign of a major deterioration in the macroeconomic outlook? Well, not quite.

Our view of the global prospects for the coming 12-18 months can be summarized as follows: First, the slowdown is coming; it is taking longer for it to materialize simply because the global economy started from a very favorable position, with strong and well balanced growth across regions, and the non-financial corporate sector enjoying high profitability and strong balance sheets. Thanks to these strengths, the real economy has been able to weather the financial crisis so far, even in the US, as cash-rich companies were partially shielded from the first stage of the credit tightening, while buoyant growth in major emerging markets continued to support the export performance in both the US and Europe. Signs of the slowdown, however, are unmistakable: in the US, a dismal performance in the housing sector is now accompanied by deteriorating conditions in the labor market, as mentioned above. In the eurozone, confidence indicators are clearly pointing south, and the non-manufacturing activity indices have already registered a significant deterioration. Across most developed and emerging economies, moreover, the relentless rise in fuel and food prices continues to erode disposable income, something which is bound to cause a significant deceleration in consumer spending. Finally, the gradual tightening in credit conditions which is clearly signaled by the bank lending surveys on both sides of the Atlantic will eventually contribute to the slowdown.

Second, the slowdown will not be as bad as was initially feared. The real economy has proved far more resilient than was initially assumed. We would not go as far as to claim that this is just a “paper crisis”, with banks burning quickly through a large part of the paper profits booked over the last few years but no real economy impact. It is a fact, however, that the financial crisis has been in full swing for a long time and, while not everyone is ready to believe that the worst is behind us, it is certainly difficult to argue that we are still just in the early stages. The fact that the impact on the real economy so far has been limited - notwithstanding a commodity shock of unexpectedly large proportions - cannot be shrugged off. This resilience strengthens our confidence that the deterioration in the growth environment is going to be limited: we are facing a moderate slowdown, and even the US will avoid a deep recession, we believe.

Third, because it is taking longer for the slowdown to materialize, the entire process of deterioration and recovery will be lengthy. Compared to what most analysts expected, it is taking longer for the overall growth performance to deteriorate in the US, and it will take longer for the deterioration to migrate from the US to the eurozone and other major economic areas. This implies that economic agents and investors will need staying power - and this might prove the harder challenge. In financial markets, many investors are getting tired of operating in emergency mode, and there is a strong desire to believe that things might quickly get back to normal. Excessive optimism should be avoided. We do believe that things will soon begin to improve, and indeed we have been seeing some incipient signs of normalization in some asset markets. But the normalization will take some time, and the end point will be quite different from what we had gotten used to before the onset of the crisis.

Similarly, policymakers should remain prepared for a prolonged period during which headwinds against economic growth will remain strong - and they should remain mindful that risks to growth are still heavily skewed to the downside. So far, most key central banks seem to be on the ball. The Fed has reacted promptly and decisively with a large monetary easing which has attracted some criticism, but which seems to have been effective so far in stabilizing the growth outlook without igniting major inflationary pressures. The ECB has stood firm and maintained a hawkish stance in the face of strong criticism, including from us. The resilience of eurozone growth data has so far proved the ECB right. The Bank of England is, in our view, in the most difficult position, as it might be facing the most intense combination of stagflationary factors. Faced with a sudden jump in headline inflation to 3.0%, the BoE indicated in its latest inflation report that it does not see any scope for further reductions in interest rates for the foreseeable future (inflation projected above target for the next two years). Governor King colorfully declared that, unlike other central banks, the BoE had not listened to the sirens calling for large interest rate reductions. By his own admission, the Governor will probably have several more opportunities to practice his prose as the projected further rise in inflation will probably require him to write letters of explanation to the Chancellor. Yet, the UK seems most exposed to downside growth risks, due mostly to the fragility of the housing and financial sectors. As elsewhere, the impact on the real economy has been limited so far, but the risk of a rapid deterioration seems more significant in the UK than elsewhere. Should it materialize, the BoE will be in a very tight spot.

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Published on  Fri, May 16 2008, 12:30 GMT

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HVB Group  | Bayerische Hypo- und Vereinsbank AG Am Tucherpark 16 80538 München
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