NEWS / Foreign Exchange

From slowfox to quickstep

Trends and risks

• Global business confidence has bottomed out - and will rise through the latter half of this year
• The US ecomony will strengthen for the rest of 2007 - as construction stabilises and manufacturing recovers
• The German locomotive is powering ahead - and Euroland will continue to perform strongly
• In Asia, the economies still look strong - and Asian currencies are expected to appreciate
• Global monetary policy tightening will continue - to counter increased inflationary risks

Contents

• Introduction From slowfox to quickstep
• USA A comeback
• Euroland A Head of Steam
• Asia A life of its own
• Alternative 1 An inconvenient truth
• Alternative 2 A convenient truth

Introduction: From slowfox to quickstep

• We have long argued that the ISM index would bottom out in Q1 2007, signalling a reacceleration of US and global industry during 2007. This scenario now seems to start unfolding. We have upped our ISM target to 55 by September. This also implies that there will be little - if any - slowdown in the European industrial cycle over the course of the year. With the US rejoining the global cycle, the expansion seems set to pick up from slowfox over the past year to quickstep over the next - the party is not over yet.
• The US economy will see weak consumer spending in the second quarter, as the rise in gasoline prices takes its toll on real incomes. However, this brake on growth is likely to be temporary. Looking to the second half of the year, gasoline prices could become a positive factor. Moreover, the stabilisation of the housing sector will boost growth noticeably in H2 2007, propelling the US economy back to above trend growth. The Fed should stay on hold, but risks are skewed towards more hikes by the start of 2008.
• In Euroland the industrial expansion continues to be brisk, and the expansion is more broad based and solid than at any time since 2000. The German VAT hike caused a drop in consumer spending at the start of the year, but industrial sentiment has so far suffered surprisingly little damage from this. ECB rate hikes and EUR strengthening will eventually take a toll on the economy, but this is not likely to become visible until 2008. We have upped our rate forecasts and now expect the ECB to take the refi rate to 4.75% by the beginning of 2008.
• Asia - and indeed most of the emerging markets universe - is still going strong. Japan will benefit from the reacceleration in global industry as it usually does, providing Bank of Japan with the necessary excuse to hike rates again in August. In China fears of overheating will lead to policy tightening - with accelerated RMB appreciation as part of the solution.
• Overall, our message is that the death of global expansion is highly exaggerated in many quarters. The US housing slowdown is not leading to a global slump. Rather, the US economy is adapting to tighter monetary policy, and is likely to lead the global economy into another leg in the expansion in H2 2007. However, with 20-year lows in unemployment rates in the OECD area, surging commodity prices and the emergence of inflationary problems in some countries, this also looks like the recipe for more monetary tightening than is currently priced in many markets.

Stronger and longer

The global expansion continues as the US picks up

In the previous two editions of Global Scenarios, we have argued that surprises were brewing in the global macro picture.

Firstly, we thought that the ISM - and hence the US manufacturing industry - would pass the trough in Q1 2007. We have consistently forecast a turnaround in Q1 for the ISM.

Secondly we have argued that Euroland??™s industrial sentiment would be weakening slightly, so that the US ISM index and the Euroland PMI would meet each other at around the 53-54 level by this summer, signalling a continued and more balanced global expansion. This relative weakening of Euroland was partly a reflection of our expectation of a temporary negative effect from the German VAT hike in H1 2007.

Finally, we have been arguing that Asian growth would continue to steam ahead, supported by the turnaround in US industry, continued firm US consumer demand, strong Chinese domestic demand and undervalued currencies.

The message in this edition of Global Scenarios is that we now seem to have been a bit too pessimistic. Euroland and US industrial dynamics are converging, as the gap between ISM and Euroland PMI has indeed now closed, as we predicted it would. But contrary to our expectation,this convergence does not look to be a ???meeting in the middle??? of ISM and Euroland PMI at 53-54. Rather, the reacceleration of US industry, with the ISM heading for the high ground above 55 will do the trick. This view is supported by most of our lead models for the ISM, which now broadly indicate a move to 55-56 by October for this index - a notch stronger than the 53-55 top we expected in Global Scenarios, March.

So, in our view, the US is in the midst of an industrial reacceleration. This acceleration is born out of the end of the inventory correction in US industry, combined with the lagged effects of a surge in consumer demand from November to March, cf. USA.

We do think that US consumer spending will be weak in the second quarter, reflecting the surge in gasoline prices in March-April. However this will not spill over into the industrial cycle until late this year.

Moreover, the upside surprise to US industrial dynamics is likely to spill over to corporate spending, which should be healthy in the second half of this year. Recent capital goods orders data seem to support this view, as orders have rebounded after the stunning weakness in Q1. Stronger orders and ISM also bodes well for hiring trends going forward, and we expect the employment reports to hold firm close to the present level in the coming quarters, with an upside risk in the second half of 2007.

Finally we think the US construction sector is set to stop being a brake on growth. Recent New home sales and buying sentiment data have supported our view that the demand side of the housing market has been stabilising since the autumn. As US residential construction spending bottoms out, US growth will improve by 1 percentage point. This alone will actually be enough to make the economy reaccelerate to above trend growth, as there has been no slowing in the US economy outside the residential construction sector.

Monetary policy tightening in the US is being felt. The housing slowdown is the product of this tightening (rather than the burst of an expectations-driven bubble). However, we don??™t think that a 5.25% Fed funds rate is tight enough to create more than housing-led ???mid-cycle blues???. Moreover, as the tightening has being digested, the economy is likely to reaccelerate back to more normal expansion growth.

This stronger and faster improvement in US industrial dynamics is good news for Euroland. Moreover the VAT-related weak German consumer spending in Q1 has had less impact on German industry than we previously thought it would. The net result is a Euroland industrial slowdown which is more limited than we previously thought it would be. Indeed, the industrial boom can continue throughout 2007, giving more fuel to the hawks in the ECB??™s steering council. We now think that the ECB can be expected to hike rates throughout the year, with the refi rate reaching 4.75% by Q1 2008.

Many investors have been waiting for the US housing slowdown to be the bogeyman which takes the US economy into recession, in turn paving the way for a global economic slowdown. However the reality seems to be a very different story. The US housing slowdown has continued to be contained within the construction sector. US consumer spending growth has not slowed, even though housing demand has been contracting for two years now.

With a contained and gradual slowing in the US, the rest of world doesn??™t really seem to care. The strong pick-up in Euroland and the continued strong expansion in the emerging markets universe is more than enough to counter US weakness. Especially as the weakness in the US economy is not broad based, but concentrated in rather sheltered sectors such as construction. While the apparent bubble in the Chinese A-share market is a cause for concern, for those invested there, the linkage between financial markets and the real economy is still underdeveloped in China. A crash in the A-share market will have a limited direct effect on the economy, just as the surge in the market has not left much of a mark on growth there, cf. Asia. Moreover, there are also still limited financial links between the Chinese stock market and global markets as a consequence of Chinese foreign exchange controls. That is partly why the bubble had room to develop in the first place: Mainland Chinese investors have had few other places to go with their stockpile of cash on deposit. We think the fears of overheating and of asset markets bubbles are triggering a new round of policy tightening by the Chinese authorities. However, this time around faster currency appreciation for the Renminbi is likely to be a more prominent part of the solution, than it was in 2004.

So, taking the broad perspective, we once again have a rather positive view on the global outlook (as we have generally had in Global Scenarios since 2003). Certainly, monetary conditions have been and are tightening, but so far none of the major central banks have taken policy to levels that are really show-stoppers. The tightening enacted so far is working, as evident in the US housing slowdown. However, monetary conditions are simply not tight enough to bring the global growth train to a complete halt. That is the overarching story of the world economy right now.

But the expansion is also getting old. Unemployment rates have passed a 20 year low in the OECD area. Commodity markets continue to signal demand/supply imbalances and strongly rising prices. Moreover, we note that inflation is starting creep up, especially in Emerging market economies with undervalued currencies and ???notso- well-anchored??? inflation expectations.

As wage growth remains reasonably well behaved in mature economies, we do not see a global inflation problem developing. But risks are rising on the inflation front in many quarters. This is particularly the case in many emerging markets, where the boom in raw material prices is felt more strongly, and where inflation expectations are generally less well anchored. This is likely to lead central banks in cycle leader countries to start moving policy to tight levels.