NEWS / Foreign Exchange

The expansion that refused to die

Trends and risks

• Global business confidence bottoming out - while Euroland still has some slowing ahead, the US and Asia will see a gradual recovery in H1
• The US is entering 2007 positioned for stronger growth - the construction sector will stabilise, industry is recovering and demand remains solid
• VAT takes shine off German economy - but Euroland is heading for a sweet spot
• In Asia, the economies still look strong - while the currencies are in the spotlight
• Further monetary policy tightening is on the cards - in Europe, Japan and, by late this year, also in the US

Contents

Introduction The expansion that refused to die

USA Positioning for stronger growth

Euroland In the sweet spot

Asia Yen and yuan in the spotlight

Alternative 1 Mr Phillips wakes up

Alternative 2 Financial risks turn real

Introduction: The expansion that refused to die

• In the US, the jitters in the subprime mortgage market are unlikely to have major macroeconomic ramifications. Contrarily, the turnaround in the housing market will begin to support the economy and the manufacturing sector will strengthen. Hence, growth has bottomed out and is heading for trend. Given continued inflationary pressures this will force the Fed to hike by late 2007.
• European industry, on the other hand, is facing headwinds from the German VAT hike. European industrial indicators should ease - even while the US strengthens. Given the increasingly tight monetary stance, the slowdown in industry should put the ECB on hold after one more hike in June.
• In Asia, we expect further economic strength as US industry picks up. Bank of Japan will be looking an excuse to raise rates again. However, it will be hard to find and we expect only one more hike in 2007.
• Overall, the global economy is not in danger of an imminent slowdown. The problem will, in fact, be too much growth - not too little, as the expansion is unlikely to commit hara-kiri. In the end, central banks will likely have to step harder on the brakes in 2008.

Global expansion is not over

US picks up as housing and manufacturing turn

The present global expansion took off in early 2003. Looking back, the financial markets??™ perception of this expansion has been jittered with ???soft patches???, and ???slowdowns???. The markets appear to have been obsessed with ???an imminent end???.

And they are at it again. The market currently sees the US economy as being in the midst of a (housing-driven) slowdown that will impel the Fed to start cutting rates soon.

Sure, the case for ???an imminent end??? is more compelling now than at any previous time in the expansion: US GDP growth did slow in mid-2006, and housing demand has been in a slump since mid-2005. Even so, we think that the bond market is fundamentally wrong about the US expansion.

One main message in this edition of Global Scenarios is that the US is not likely to see growth below trend in 2007. On the contrary, GDP growth looks set to pick up again as early as H1 2007.

The US slowdown in mid-2006 was driven by two inventory corrections - one in the housing market related to the softening of housing demand since mid-2005, and one in US manufacturing, as reflected by the drop in the ISM index from above 56 last summer to below 50 in January this year.

A central call in this issue of Global Scenarios is that both these inventory corrections are almost at an end.

Housing demand has been stabilising in the US since autumn 2006. As we highlighted in ???Research USA: US housing bottoming out???, from October 2006, this is not as surprising as one might think. Further, the inventory correction in manufacturing is almost over. US consumer spending picked up in November 2006 as we forecast it would in ???Research USA: Housing slows - but consumption might not??? (August 2006) and in Global Scenarios, November 2006. The pick-up was not due to warm weather. Neither was it an aberration. It was a reflection of the autumn drop in energy prices that boosted US real incomes and hence spending.

This is not to say that we discount the housing slowdown as irrelevant for US consumers, but housing is not the only important driver for US consumer spending. And with the other spending drivers - energy price trends, the labour market, interest rates and real income growth - remaining supportive, US consumer spending is likely to hold up pretty well, even after the temporary boost from energy prices fades in Q2 2007.

The pick-up in consumption has dramatically improved the inventory/sales balance in US manufacturing (see ???USA???). As we highlighted in ???Research Global: Business to trough out???, February 2007, this implies a rising US ISM index until summer this year (see chart below). The chart also illustrates our track record for forecasting ISM turnarounds.

Fading inventory corrections in US manufacturing and housing imply a boost to US growth in the short run, and we expect growth to return to trend by the summer. Yet again, the US expansion will simply refuse to lie down and die.

This is good news for the rest of the world. While the market has been assuming that the US slowdown would be an isolated event, with the rest of the world continuing to hum along, this was never really likely. As we pointed out in Global Scenarios, November 2006, the market is excessively optimistic on European manufacturing versus US manufacturing. A downward move in European PMI relative to the US ISM is on the cards for H1 2007. Actually, the rise in the ISM in February means it has already begun.

The relative decline of European industry versus US industry will be exacerbated by the effects of the German VAT hike. However, the VAT hike is not the sole or even the main reason Europe will weaken relative to the USA (see ???Euroland???).

It is important to emphasise that the slowdown in Europe will be a manufacturing slowdown and a VAT-related temporary slowdown in German consumer spending. It is certainly not the end of the European expansion - just as the drop in the US ISM index during the autumn reflected a temporary slowdown in US manufacturing (due to excessive inventory growth) rather than an end to the US expansion.

In fact, the European story has been one of gradual recovery for many years. And this is not likely to end in 2007.

For Asia, the pick-up in the US is also great news. Asian growth still has good momentum - and with the US expansion continuing in 2007, rather easy local economic policies and weak currencies, the Asian boom looks far from over.

In the short term, the worries about the US economy will continue to hang over the market and the central banks. The Fed will stay on hold until the autumn, when we expect a Q4 hike. In Europe, the ECB will go on hold in June, after hiking to 4%. Meanwhile, Japan??™s central bank will continue to look for an excuse to hike rates. But the BoJ is unlikely to find support for more than one additional hike in 2007. Hence this year will not be one of serious monetary tightening - although, neither will it be one of monetary easing.

For us, the bottom line is pretty simple. It is na??ve to think that the global expansion will commit suicide. While central banks have generally eased the pressure on the accelerator, none have really applied the brakes - the expansion will not die before they do so.