NEWS / Foreign Exchange

EMU: Unimpresse by US slowdown

• Weakness: The US economy continues to lose momentum. The crisis in the subprime mortgage market is accentuating the housing market recession, mass layoffs by the Big 3 automakers and falling equity prices are weighing on consumption, and even corporate investment is now showing signs of weakness. This underpins our cautious US economic forecast.
• Strain. Globally, however, the US slowdown is having less of a retarding effect than in previous cycles. The world economy has become more robust. Asia??™s upswing is increasingly driven by domestic demand. The same is true for Eastern Europe. And high commodity prices are helping commodity producing countries.
• EMU. That is supporting growth in the eurozone while making it less dependent on the US cycle (cf. chart below). Exporters switched their focus to the growth regions in time. In addition, unexpectedly strong foreign demand is triggering additional investment spending.
• ECB. This, combined with robust domestic demand in EMU, translates into upside risks to our EMU GDP forecast of roughly 2??% for this year and next ??“ despite the technical setback at the beginning of the year in both Germany and Italy (pages 5-7 & 8-9). As a result, the risk that the ECB will raise its refi rate above the 4% projected so far continues to rise.

Further topics:

• Weekly Comment: "Subprimemania".
• Swiss National Bank to tighten one more time.
• Crude oil supply to become tight again sending prices higher.
• Data outlook: Fed on hold; Italian consumer confidence to rise.
• Market outlook: Bonds and euro remain well supported.

"SUBPRIMEMANIA"

Sub-prime concerns have come decisively to the surface again, and are likely to stay with us for a while longer still. I should stress up front that we are not overly worried. We were convinced, and had warned our readers, that the problems in the housing market were not over yet and would continue to undermine economic activity for the first part of this year.

Given the extent to which lending standards had been relaxed in the sub-prime segment of the market, with a reckless combination of teasing incentives and weak credit checks, it should not be surprising that default rates are now rising. And it is not surprising that some of the lenders who gambled most recklessly on this segment of the market are now running into serious difficulties, and do not find anyone willing to throw them a lifeline. There is also no doubt that the corresponding repossessions, adding to the existing stock of unsold homes, will prolong the laborious process of working through the still high inventory and therefore keep the housing market soft in the months ahead. If there is anything surprising here, it is how much of a surprise the sub-prime woes seem to have been.

The recent troubles, however, do not alter our fundamental picture on the US economy. The slowdown currently underway is playing out along the lines we had anticipated??”if anything, the resilience of the labor market, wage incomes and consumption has surprised us a bit on the upside. We therefore remain sanguine on the outlook for the US economy.

This will be a lackluster year, to be sure, but one where the US economy will continue to chug along at a reasonable rate. The sub-prime sector, even though it boomed over the last couple of years, still accounts for only some 10%-15% of outstanding mortgages. Even with the sharp rise in default rates, this is not enough to send the housing market and private consumption into a freefall.

The markets??™ reaction to the problems in the subprime mortgage sector is, in our view, dictated mostly by the uncertainty on where the exposure to the sub-prime sector really lies. We know that subprime mortgages have been given out with abandon also because there was a strong appetite for new mortgages that could be sliced and repackaged into various forms of structured products which banks would then sell on to various categories of investors.

Hence, the concern was that defaults on sub-prime mortgages could eventually trigger the collapse of some hedge funds and cause serious losses in mainstream banks. This has been evident in the last few days, as the share prices of some of the largest banks have registered significant losses. However, one should not forget that the same banks have just enjoyed an extremely profitable run, which should have provided them with an important cushion. So far, I have not seen any convincing figures that might suggest that the problems in the sub-prime mortgage market could trigger losses of the magnitude seen in the savings & loans crises and thereby unleash a credit crunch.

This goes back to our first reaction when volatility jumped up two weeks ago: there is nothing in the fundamentals justifying the current market reaction, and concerns about the US growth outlook in particular are overblown. There is a crisis of confidence, as investors had become increasingly uncomfortable with the stretched valuations prevailing in most asset markets. The correction so far has been moderate, and by no means sufficient to allay investors??™ concerns over valuations, notably in light of the above described uncertainty over the risk allocation brought about by structured derivatives products.

We therefore expect uncertainty, nervousness and volatility to continue over the next couple of weeks, and with a tendency for the market to still overreact to negative news and "underreact" to positive news.

It is also important to note that it all goes back to liquidity: it is liquidity that has boosted asset prices, and it is a liquidity/credit crunch that markets are particularly worried about. On the other side of the barricade, it is liquidity that central banks are also worried about, but with an eye to trying to engineer an orderly mopping up. This is why we expect the Fed to remain focused on inflation risks, and keep rates on hold, and we see increasing upside risks to our 4% ECB call; rate hikes this week by the SNB (with hawkish statement to boot) and the Norges Bank also go to confirm our view that the central banking world remains under a hawkish spell.