NEWS | Wednesday, 30 January 2008

Slowing economic growth rates across the board

Kevin Polidano, Investment Analyst, Bank of Valletta plc analysis the global economic outlook for 2008

Despite sluggish growth in the United States in the first half of 2007, both Europe and Asia managed to post rather high growth rates, but is this sustainable?
Dependence of many major economies on the US has declined in recent years. The US economy is poised to continue to weaken and in the first half of 2008 may find itself very close to a recession. This will definitely have repercussions on the rest of the world, including emerging markets. The fallout from the subprime crisis continues to be felt and the US housing market shows no sign of bottoming, keeping uncertainty regarding the economic outlook at an unusually high level.
Most economists believe that there is around a 50% probability of a slight recession.
As employment and wage growth slow down, US consumers are being hit by falling house prices, tighter credit conditions and high energy and food prices. Consumer confidence has already fallen to recession levels while business confidence, although mixed, is faltering. Fortunately, the recession scenario is not yet inevitable. There are some positive forces, where employment is still rising albeit more slowly and joint intervention from governments through easing of fiscal policy and central banks intervention should act as a good supporting play.
Monetary policy was not particularly tight at any point in the current economic cycle. Generally, recessions begin when central banks over-tighten in an attempt to dampen inflationary pressures. While the Federal Reserve ultimately lifted interest rates by a substantial 425 basis points, they were lifted from a record low of 1%. So as to offset rapid economic downturn the Fed is still expected to lower interest rates further.
The European economy looks set to have grown by around 3% in 2007, a little above its long run average, but the outlook for 2008 looks less positive. A combination of higher official interest rates as loans re-price and widening financial markets spreads have left the economy in a precarious position. The European Central Bank maintained a hawkish bias throughout the year, but this may be based on an overly optimistic economic outlook and to fend off rising inflationary expectations.
Corporate investment remained solid, reflecting high capacity utilisation rates, good profitability, optimistic business expectations and growing business exports. Nonetheless, the outlook for European Monetary Union is also clouded by recent events in financial markets and their possible impact on the real economy, with the British economy likely to be hit the hardest.
Although financial markets are currently pricing in further rate hikes in the second half of 2008 we are inclined to expect that the ECB may likely keep interest rates on hold for the first half with increased probability of easing monetary policy in the second half of the year. As global growth dwindles, inflationary pressures should eventually abate, hence prompting the ECB to cut rates and focus more on growth. On the other hand markets are expecting the Bank of England to cut interest rates as weaker consumer spending takes its toll on the economy.
Latin American economies had a resilient performance, supported by evident improvement in economic and financial fundamentals in the last few years. Countries like Mexico and Venezuela remain the two major countries exposed to a US slowdown, while the whole region is significantly vulnerable to any possible downtrends in commodity markets.
Exports are central to the growth dynamics of most economies in Asia and the key markets for Asian exports are still the US and EU, more than China or any other economy. A global slowdown in economic growth should eventually lead to weaker growth in the region. Conversely most of the Asia-8 group will be investing heavily in infrastructure. This is likely to dampen some of the effects of slower net exports growth.
China posted an estimated growth rate of 11.1% in 2007. China’s growth rate is expected to slow to 9.8%, but not as a consequence of a US slowdown. Domestic demand was very strong in 2007 and this trend is expected to continue in 2008, with accompanying risks of overheating and asset bubbles. Inflationary pressures should prompt the Bank of China to tighten monetary policy.
The Indian central bank is also likely to tighten monetary policy as the growth rate is expected to remain unchanged at around 8.8% in 2008 spurring further inflationary pressures. Asia excluding Japan is well placed to weather a moderate global economic slowdown, but not a sharp downturn (downtrend implying OECD GDP growth slowing below 1% in 2008).

Bonds: quality matters
Investors have shifted their focus from seeking higher returns to a strategy of risk aversion. In the past couple of years, an environment of very low corporate defaults and strong global growth sparked an aggressive search for higher yields outside government bond markets. The four year run of corporate bond outperformance came to an abrupt end in June 2007. News about sharply rising defaults among US subprime mortgage borrowers resulted in a sharp re-pricing across all risky assets. We expect this to keep credit spreads elevated. Eventually spreads should narrow from current wide levels but a return to the tight spreads of pre-July 2007 is unlikely. Defaults will likely trend higher in 2008 under all different scenarios while economic growth should stay on weaker track compared to recent years, profit growth will also slow and access to capital for lower rated creditors will become tougher. In general, we believe that investors should focus on good quality issuers and avoid high yield bonds, or else be very selective on non investment grade issuers.

Equities: not the ideal place for the weak hearted
Market volatility was a very common headline in 2007; such a market trend is expected to continue well into 2008. Crude oil and gold rallied to new highs during the fourth quarter, and the best performing markets in 2007 were emerging markets and commodity related stocks. Meanwhile the massive write downs among large banks and brokerage firms caused financial stocks to dramatically under perform.
Large European and American markets are poised to hold up better in such a turbulent market, because most companies listed in both regions have global operations and earn profits in more than one region. Price to earnings ratios are also significantly below historical averages which bodes well for future performance. Potential for the Japanese markets to outperform is still somewhat limited, despite having lost much of their valuation premium.
Less developed markets should post in a stable performance in 2008. However investors should exercise a greater degree of caution and be more selective as strong performance over the past few years has led to increasingly stretched valuations.
Exports remain a big proportion of Asia’s GDP. Economies reliant on US exports such as Taiwan, Korea, Malaysia and Singapore would be hit hard by a US recession. In this same scenario, smaller Asian markets like Indonesia, Thailand and the Philippines are likely to hold up best. Latin American stocks would also be adversely affected by a US recession, with the Mexican equity markets more susceptible to a downtrend than the Brazilian counterpart.
Many emerging market countries whose currencies are pegged to the US dollar would experience counter productive easing of monetary policy if they continue to pursue a rigid US dollar peg. This should induce faster growing emerging market economies to tighten monetary policy so as to counteract the adverse repercussions from the dollar peg. Failure to tighten monetary policy would lead to higher consumer prices and possible asset price bubbles in such markets.

Prevailing themes to focus on in 2008:
• European markets preferred over the US markets
• In Europe focus on the continent rather than UK
• Focus on large caps
• Consider shifting to value stocks during 2008.
• Focus on companies with sound cash flow and balance sheet positions and potential for re-leveraging (increase debt levels)
• Focus on multinational companies.

Currencies - volatile as ever
The trademark of 2007 in the currency markets was the sturdy depreciation of the US dollar. As risk aversion increased during the year, investors grew more cautious on carry trades (that is borrowing in low yielding currencies like the JPY and CHF and investing in high yielding currencies like the AUD and GBP) Such positions and carry trades are losing their appeal as risk aversion increases.
The US dollar should climb against the euro as most of the rate cuts expected in the US are fully priced in, while none of the possible rate cuts that could occur in the second half of the year for the European monetary union are being currently factored in. This should help the dollar to gain some ground in the second half of 2008 after a six year downtrend versus the euro. Such an appreciation would be tested, should a full blown recession scenario occur resulting in further downside pressure on the greenback. On the other hand USD weakness looks likely against emerging currencies, especially those in Asia.
After the US and Japan, the UK is the major economy most at risk of suffering a severe slowdown in 2008. This should dent the prospects for the sterling.

Commodities: consolidate near current levels
After a weak start to the year, crude oil and other energy commodities rallied to all-time highs during the second half of 2007. In 2008, we expect energy prices to consolidate as market participants focus more on the underlying supply and demand situation. On one hand, demand is expected to remain strong from China and Europe. However the slowing US economy should take its toll on the demand for crude oil since the US still consumes one quarter of global production, almost as much as China and Europe together. OPEC countries are also expected to increase production. Although OPEC now seems to be set on keeping oil prices nearer $90 rather than $50 a barrel, a US recession is not in OPEC’s interest so more flexibility in supply is likely, probably allowing the oil price to settle back closer to the $70 - $80 level in 2008 than the $100 level mark. Geopolitical tensions will once again one of the major risks looming on the oil market.
Gold has risen on inflationary fears, increased demand from India and Middle East as well as a weaker dollar which has spurred the precious metal to multi year highs. Financial market uncertainties and further dollar weakness provides support for high gold prices. At the moment there are no signs of over valuations.
Meanwhile, investing in agriculture is expected to be very challenging, because demand and supply conditions can change rapidly, even within a year. Inexperienced investors should get exposure through broad based funds. After a stellar performance this year demand for wheat is expected to slow as producers planted more wheat in 2007. Copper is likely to be the most exposed should the US enter a recession. As in the past three US economic downturns, copper inventories have doubled within three months of the US entering a recession. However underling strength in Chinese GDP growth should eventually rescue the copper price. The one metal that has tended to be most resilient to Fed easing has been aluminium.