• Global economy. The global recession is winding down and global GDP is expected to return to growth this quarter. Soft as well as hard data are clearly heading north. The pacesetters are Emerging Asia and there are even promising developments in Japan. The global economic recovery, however, will be rather moderate and bumpy; we expect a W-shaped recovery.

  • US. Real US GDP will likely see robust growth in Q3 with 3¾% on an annualized basis, due to the government stimulus program, the welladvanced destocking process as well as the successful “Cash for Clunkers” initiative. This, however, is merely borrowed growth. We therefore expect an increase of only 1% in 2H 2010 (pages 4-7).

  • Germany. The same holds true for Germany. After a minimal decrease last spring, real GDP will likely grow at a (non-annualized) 1% in 3Q followed by 0.7% in the final quarter of this year. (Global) industrial demand will provide the tailwind. However, in the first half of 2010, GDP growth rates are likely to decrease by half again (p. 10-11 & chart below).

  • EMU. While the rest of the eurozone is slightly lagging behind, the recession has softened considerably. We anticipate a 0.5% decrease for 2Q (I/09:-2.5%). And the improvement in manufacturing – the sector that was hardest hit after the Lehman bankruptcy – makes it increasingly likely that the eurozone could exit negative growth territory already in the current quarter (pages 8-9).

  • Other topics:

    – Comment: Prudence (page 2).

    – Data outlook: Recession winding down in EMU region; US retail sales and industrial production with strong growth (page 12).

    – Market outlook: EUR remains in demand; Bund yield curve to steepen again (page 20).


Prudence

Not for the first time, the Bank of England surprised markets, while the ECB offered a reassuring sense of predictability. The common thread, though, is that both central banks are taking a very cautious view of the recent improvement in activity indicators and are not at all willing to risk a premature withdrawal of policy stimulus. This is the right stance. Over the next few months, there is in my view a significant upside risk to economic data, driven by the combination of a faster turnaround in the inventory cycle, a faster recovery in global trade, and the delayed impact of fiscal stimulus programs: activity across the global economy could easily accelerate beyond what is currently expected, raising hopes that we are headed for a robust and sustained exit from the recession. However, given the fragility of the private consumption outlook in the US and Europe, momentum will then likely abate at the beginning of next year, leading way to a moderate and gradual recovery. Against this background, policymakers are wise not to build up excessive expectations on the pace of the recovery, as the subsequent disappointments might undermine confidence in the policymakers themselves. Trichet confirmed that credit growth is a key area of concern, but conceded that banks need to be mindful of risk as they extend credit. He tried to de-emphasize differences in the economic performance of individual euro-zone economies. Yet, in my view, this is going to pose a major policy challenge to the ECB going forward, with an increasing degree of decoupling among the euro-zone economies as the recovery takes hold. With inflation seen as subdued throughout the policy-relevant horizon, we will be well into next year before we need to worry about the ECB’s exit strategy, and Trichet yesterday left all options open in terms of the sequencing of exit measures – indeed, we could imagine that the ECB could start hiking rates while still providing support to specific market segments. The GBP was hammered in the immediate aftermath of the BoE announcement, but this in my view could actually offer additional upside potential if risk appetite strengthens further in the coming months.

The Bank of England unexpectedly announced an extension in its Gilts purchase program, from GBP125bn to GBP175bn, with the extra GBP 50bn to be deployed over the next three months and involving a broader range of Gilt maturities than previously envisioned. The BoE therefore steps up its QE program notwithstanding a significant improvement in recent data, including a sharp rebound in the manufacturing PMI, which surged above the 50 threshold in July from 39.5 in March, and a surprising acceleration in June retail sales.

Recent data have raised hopes that the global economy might enjoy a stronger-than-expected rebound: China’s recovery is proving surprisingly dynamic, the US economy appears to have turned the corner and left the long period of negative growth rates behind, and even in the eurozone we have seen some encouraging signs of stabilization.

ECB President Trichet stressed that the ECB is looking at these signs of improvement with prudence and caution. He emphasized that signs of stabilization are so far in line with the ECB’s own forecasts, rather than constituting a major positive surprise, and that so far they only amount to a deceleration in the pace of economic contraction. He also warned that economic data will display high volatility in the coming months, implying that positive surprises will alternate with disappointments. While explicitly leaving the door open for a possible revision in the projected 2010 growth path, Trichet confirmed that we will have to wait for next year to see first a stabilization and then a gradual recovery. Unemployment represents a major challenge, according to the ECB, as it might undermine domestic demand and therefore the sustainability of the recovery. In this regard, Trichet called on governments to accelerate measures to facilitate the re-entry of unemployed workers into the labor market. According to Trichet, both economic and monetary data confirm that inflation pressures will remain subdued over the policy-relevant horizon, while inflation expectations remain well-anchored. The message is clear: the eurozone is navigating this period of negative inflation rates without accident so far, and deflation is not a danger – but inflation risks are also nowhere to be seen on the horizon. This benign inflation outlook allows the ECB to take a relaxed and pragmatic approach to the issue of an exit strategy: Trichet stressed that the ECB’s liquidity and credit easing policy has relied on measures that can be easily unwound, and he reiterated the bank’s commitment to withdraw stimulus in a prompt and timely manner once the economic outlook improves sufficiently. Trichet stressed that there could be no doubt on the ECB’s ability to withdraw stimulus, and that there should not be any doubt on its willingness to do so in a timely manner. He argued that the ECB’s credibility in this regard had been strengthened by its decision to hike interest rates last summer. In my view, this reference to the July 2008 rate hike is misguided, as that decision to raise interest rates in the midst of a recession and in the absence of any meaningful second round effects from the oil price rise was a clear policy mistake, which if anything undermined the ECB’s credibility. In my view, Trichet should remind consumers and market participants’ of the ECB’s courageous decision to open its tightening cycle in late 2005 against strong opposition and criticism of most analysts and international institutions.

Trichet tried to de-emphasize differences in the economic performance of individual euro-zone economies. Yet in my view this is going to pose a major policy challenge to the ECB going forward: while Germany is clearly well positioned to quickly capitalize on the rebound in global trade, other economies such as Italy run the risk of being left far behind, and the long standing “one size does not fit all” problem will represent itself with a vengeance. Credit growth remains the most important variable: Trichet argued that while the slowdown in credit growth was mostly demand-driven, supply effects were now undeniable; with growth rates for M3 and for loans to the private sector now at the lowest levels in eurozone history (-3.5% and +1.5%, respectively), the risk of a credit squeeze cannot be dismissed. Trichet therefore reiterated his call on banks to do their part and pass on liquidity in the form of loans to the private sector. At the same time, Trichet this time acknowledged that as banks had been criticized for excessive and reckless credit extension in the pre-crisis period, they should not now be pushed to lend without due regard to credit risk considerations.

Bottom line: we continue to believe that it will be well into next year before we have to worry about the ECB’s exit strategy, including rate hikes.