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Global Scenarios: Trends and risks

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While the US shows, Europe slows

Tue, Nov 28 2006, 12:08 GMT
by Danske Research Team

Danske Bank A/S

Trends and risks

• The global industrial slowdown will mature further early in 2007 - increasingly spreading to Europe and Asia
  
• The US construction sector is still in recession - but consumer demand will re-accelerate in the coming months
  
• Germany has prevented a significant slowdown in Europe - but further slowing is on the agenda in 2007
  
• Asian economies are slowing - but will continue to grow in a lower gear
  
• Further monetary policy tightening is on the cards - in Europe, Japan and, by late H1, also in the US

Contents

Introduction While the US shows, Europe slows

USA Fed waiting for visibility to improve

Euroland Slowing in spring

Asia Is it slowing?

Alternative 1 Genie out of the bottle

Alternative 2 Housing crunch

Introduction: While the US shows, Europe slows

• Along with a slowing US economy the global industrial slowdown has matured further in the autumn. While we expect the global industrial cycle to edge further down in the coming months, resilient domestic demand growth in Europe and the US will prevent the industrial downturn from developing into a more pronounced global growth slowdown.
  
• Large regional differences between the US and Euroland have emerged during the autumn. While US industrial indicators and growth have slowed, Euroland data has remained remarkably strong. The present market pricing suggests that this picture of Euroland outperforming the US will continue into 2007.
  
• However, contrary to the market, we think it is too early for a slump in the US. Strong real wage growth and a beginning of stabilisation in the housing market will provide an upside surprise in growth during Q4 and Q1. Combined with a continued uptrend in core CPI inflation, this will set the stage for several additional Fed hikes during 2007.
  
• Euroland, on the other hand, will see a negative surprise as we enter 2007 - at least compared to the US. We suspect that the upcoming VAT hike has prolonged and amplified the industrial upswing. However, the VAT hike and the slower global industrial environment during the autumn will kick back in early 2007, resulting in a weakening of Euroland industrial growth indicators. This will pave the way for a pause in the ECB hiking cycle. Consequently, there is a relative surprise in the growth picture in the pipeline.
  
• In Asia the growth picture has become somewhat softer. In Japan growth has slowed, led by sluggish consumer spending, and in China the tightening campaign and the slowing global industry has begun to show its impact. However, we don’t expect the current slowing in Asia to develop into a more serious slowdown as the structural recovery in Japan and the catch-up process in China will continue.

A 2007 surprise is brewing

Global industry is slowing, but less in Euroland
Since May we have emphasized that one of the main themes this autumn would be the slowing in global industry. As we have argued, this slowing is mainly related to a slowdown in global trade and a downward correction in global inventories.

We also emphasised that underlying domestic demand in all three major regions is likely to slow only modestly and that the current industrial downturn would not develop into a serious global slump. On the contrary, resilient underlying demand will keep the global expansion going, leading to a rebound in global industry during mid- 2007. We still hold these views, with the minor adjustment that the industrial downturn now looks to become a bit more prolonged than we had initially anticipated.

While the picture of global industry losing momentum and domestic demand remaining robust complies with our message from Global Scenarios September, we have been somewhat surprised by the size of the regional differences.

While the US ISM has slowed consistently from its peak in the late spring - broadly following our forecast - we have barely seen any easing in Euroland PMI. We believe that the divergence this autumn has primarily been driven by lagged stimuli to the two regions and possibly big ticket spending in Germany due to the upcoming VAT hike. To a lesser extent, the divergence also results from the significant US housing slowdown, and from a more fundamental improvement in German economic trends.

Markets are wrong about US vs Euroland outlook
At present, this picture is reflected in financial market pricing. Markets are telling us that, in the US, growth will be slowing in 2007, thus paving the way for Fed cuts in spring. At the same time, the market thinks the ECB will pause after an additional rate hike in December - and perhaps Q1. Implicitly this is the story of a global slowdown, but one that is centred on the US - presumably with the US housing market playing a prominent role.

As always, the task for investors is to look at what the markets are telling them - and think differently. In our view, there are two major ways in which you should think differently now.

It is still too early for a big US slump
Firstly, the market underestimates the outlook for US growth and core inflation in 2007. As we show in USA, there is a strong case for a pick-up in consumption growth in the coming months, driven by the surge in real income growth.

Moreover, the housing market data shows all the usual signs of stabilisation: Sales of new homes have been flat for more than six months. Housing starts has been sufficiently below new home sales to see inventories of unsold homes falling over the past three months. This implies that the drag on growth from the residential construction sector is set to diminish from now on.

Surely weakness in house prices is a drag for consumer spending growth, which will stay with us into 2007. At least when compared to the strength from recent years. However, the acceleration of real income growth - to above 4% y/y - looks strong enough to counter the negative impact from the slowing housing market.

Finally, US core inflation is on a fundamental - albeit slow - uptrend. The recent slowdowns in core PPI and core CPI inflation are likely to prove just as temporary as the slowdown in core inflation in 2005. Moreover, the uptrend in inflation is not likely to disappear before the next US recession.

In this environment rate cuts are not likely to materialise. On the contrary we think the Fed will be forced to hike the fed funds rate several times in 2007.

Euroland is going to slow
The second area in which investors should think differently is when it comes to the relative European/US growth picture. As the chart below shows, the relative steepness of the US and European money market curves is rather large. Moreover, the relative steepness is closely linked to the relative levels of industrial growth indicators, such as the difference between the Euroland PMI and the US ISM index.

Presently the market seems convinced that Euroland will be sheltered from the current industrial slowdown. However, this view is likely to be as illusionary now as it was in 2000. The global industrial sector has hardly become less interdependent since 2000.

Contrary to the US, where much of the adjustment in the industrial sector has already taken place, the Euroland industry has barely slowed as German industry has remained remarkably resilient during the autumn. While some this recent strength could be a reflection of the maturing structural recovery in Germany, we suspect that the main explanation is to find in the introduction of a German VAT hike of 3% on January 1, 2007.

Just as the VAT hike is currently boosting the European industrial, it is likely to do the opposite as we enter 2007. Hence, the VAT hike will postpone and exacerbate the downturn in European industry (see our report Research Germany: VAT rollercoaster - but recovery intact from October 30).

While we think that the Euroland economy is only heading for a mild slowdown, the reaction in European PMIs is likely, as always, to overshoot. From this perspective we think that Europe will deliver a negative surprise vis-à-vis the US (see Euroland).

The chart above shows our +6M forecasting model for the relative level of Euroland PMI compared to the US ISM. The model has been rather good so far at forecasting turns in the relative strength of Euroland. And the direction going forward is clear: European industrial indicators will start to underperform US ones during spring 2007.

Hence, a case is building, in our view, for being long European bonds against US ones.

Asia slowing down too
One development that is surprising us at the moment is the weakness in Japanese consumer spending. While Japanese data can be volatile and hard to interpret, they are showing a slowdown in consumer spending, led by car sales (see Asia). We still see this weakness as temporary, as the fundamental drivers of Japanese consumption - including the labour market - remain broadly supportive. However, Japan does appear to be losing some steam, which is also reflected in the underperformance of NIKKEI225 vis-à-vis the US S&P500 index over recent months.

In China, the economy is also showing signs of slowing from its breakneck growth pace. This is a response to the slowing of the industrial cycle and the tightening of credit conditions and fiscal policy. However, we continue to see the instruments used by Beijing to reign in growth as rather inefficient, and we do not think a serious slump is in the pipeline here either, at least not given our rather sanguine view on US growth in early 2007.

• Download full Global Scenarios - Trends and risks

Published on  Tue, Nov 28 2006, 12:56 GMT