• The German IFO survey of the business climate declined for the fifth month in the last six in August.
• The headline measure fell to 94.8 from 97.5. The assessment of current conditions and expectations components were both lower on the month. Expectations fell to their lowest level since early 1993, when Germany was just emerging from recession. All industry components fell except for wholesale trade.
• The industrial sector, which has been a strong point in the German economy, was hit particularly hard as its sub-index registered a nine point decline.
• The flash estimate for Euro-zone consumer prices showed that inflation fell to 3.8% in August, from 4.1% the previous month.
• Softening growth is likely to lead to a continued easing in resource utilization which, based on historical relationships, means that inflation is likely to continue to fall.
• As inflation is the European Central Bank’s paramount concern, the low inflation numbers should allow the Bank to lower interest rates eventually in response to a slowing economy. The aforementioned trends make recent hawkish commentary by ECB members Bini Smaghi, Liebsher and Weber look increasingly misplaced.
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Highlights
- UK real GDP was unchanged in the second quarter, ending a run of 63 consecutive quarters of growth.
- US housing starts fell to a new low for this cycle in July.
- Surveys suggest that confidence in US manufacturing is recovering.
- Leading indicators in the UK and the Euro-zone are falling at a pace not seen since the early 1990s.
- After its recent slide the oil price recovered a little on tensions between the US and Russia over Georgia and Syria.
Views
- The composition of UK growth – in particular the large contribution to growth from inventories – suggests real GDP will contract in the third quarter.
- US housing starts are falling at a much reduced pace compared to last year and the drag on the economy from residential investment should begin to fade.
- Activity in manufacturing is helping to limit weakness in the US economy.
- The risk of a recession in the UK and in the Euro-zone is mounting.
- Any sustained recovery in the oil price is likely to be bad for financial markets and the dollar’s exchange rate.
Highlights
• The Bank of England released its quarterly inflation report showing an inflation profile which undershoots its 2% target by the end of 2009 based on market rates.
• The eurozone economy contracted in the second quarter.
• Eurozone inflation held at 4% in July.
• Chinese inflation continued to fall in July whilst fixed investment growth picked up.
Views
• The BOE’s inflation profile was somewhat inconsistent with its growth profile which showed growth picking up sharply into the end of 2009. Overall, the report appeared to be dovish.
• Eurozone growth fell 0.2% in the second quarter and our model is forecasting a recession in the next two quarters.
• There are signs that Eurozone inflation may be near its cyclical peak as resource utilization has rolled over.
• Easing inflation means that the Chinese authorities can begin to implement policies to support growth.
Highlights
• The US Federal Reserve, the Bank of England, and the European Central
Bank all left their respective interest rates on hold.
• Purchasing managers’ surveys point to slowing growth.
• The Reserve Bank of Australia (RBA) also kept their interest rates at
7.25%.
• The Australian dollar has fallen by over 7% from its recent peak.
• Equity markets remain volatile.
Views
• Although the ECB recognise the weakness in the region’s economy, they will also be concerned about the outcome of current wage rounds.
• Similarly the threat of inflation may prevent the BoE and Fed from reducing interest rates to stimulate demand.
• If the RBA do proceed to cut rates, the narrowing of interest rate differentials could see further declines in the Australian dollar.
• While uncertainty surrounds the extent of the slowdown of growth and investors remain wary of the financial sector, volatile equity markets could persist.
• If confidence in the Euro-zone keeps falling at its current pace, the economy could come close to recession in the next few quarters.
• The fact that the euro is struggling to make new highs against the US dollar may be down to increasing evidence that the Euro-zone economy has ‘re-coupled’ to the US economy.
• The UK economy could come very close to a technical recession (two quarters of contraction).
• Until the overhang of unsold homes in the US is shifted, prices are likely to keep on falling.
• Higher inflation is creating a dilemma for monetary authorities in Asia who are afraid that raising interest rates will add to pressures that are slowing economic growth.
Global inflation has increased markedly in the past year due to sharp rises in energy and food prices. As this has played out against a backdrop of slowing demand, it has hindered central banks from loosening policy to accommodate the weaker growth. Trends in unit labour cost and core inflation suggest that we may be nearing an end to this ‘stagflationary’ environment.
• The euro rose very briefly above $1.60 again last week, largely due to worries about the US financial system, and about the two big mortgage agencies, Fannie Mae and Freddie Mac, in particular.
• No one seems to dispute that at this level the euro is overvalued against the US dollar and that may be a major factor in preventing it rising decisively above the $1.60 level.
• But the catalyst for a reversal of the euro’s six-year uptrend remains elusive. It may need US interest rates to rise and Euro-zone interest rates to fall before the euro can fall back closer to fair value.
• One factor that might swing sentiment against the euro and in favour of the US would be a marked slowdown in industrial activity in the Euro-zone, relative to that in the United States.
• At first glance, the news that industrial output contracted by 1.9% in May in the Euro-zone, while it increased by 0.5% in the US in June, would appear to offer some support for the dollar.
• However, taking a longer-term view, developments in industrial activity in the US and the Euro-zone have been very similar. This suggests that the two economies have never ‘de-coupled’ and that industrial growth is not a driver of the exchange rate.
A terrible first half to 2008
The first half of 2008 was an awful one for financial markets. Equity values plunged. The Morgan Stanley Capital International (MSCI) All-Country World index fell by 14% in local currency terms. All major equity markets recorded double-digit falls. Bonds fared a little better but returns were poor. Although 10-year yields in the United States were little changed during the first six months of the year, yields rose in Europe, the UK and Japan.
There were a number of reasons for this terrible performance.
First, more losses emerged in the financial system as a result of the collapse of the US sub-prime mortgage market. The US investment bank Bear Stearns had to be rescued, in a move orchestrated by the Federal Reserve, by JP Morgan.
Second, soaring food and oil prices pushed inflation rates to levels not seen since 1999. In some countries, this led to an increase in interest rates. In others, expected interest rate cuts became less certain.
Third, global economic growth slowed and leading indicators, such as business and consumer confidence, suggested that it would weaken further in the second half of the year. As a result, expectations of corporate earnings were cut.
Higher oil prices contributed to the deteriorating growth and inflation outlook. Over the first six months of the year, the oil price increased by 46%.
Second half of 2008 – not much better so far
Showing no respect for the calendar, the second half of the year has continued in much the same vein as the first half. The oil price has risen to new record highs around $145 a barrel, there has been a scare about the financial health of the US’s two large mortgage agencies – Fannie Mae and Freddie Mac - and equity markets have already fallen by 5% or more in the first two weeks of July. The only good news is that bond markets have been stronger, with prices rising and yields falling.
It appears that financial markets are now more worried about the outlook for economic growth in the second half of the year, and in 2009, than they are about the short-term outlook for inflation.
Will the rest of 2008 be any better?
It is easy to be pessimistic about the rest of 2008.
It is unlikely that we have yet heard all the bad news that is to come out of the financial sector. More losses related to the US housing market are likely to be reported. Some smaller banks in the United States could close down. And there may need to be more action from the Federal Reserve and the European Central Bank to stabilise matters.
Meanwhile, global inflation, which is already close to 6%, will climb even higher. In the Euro-zone and the United Kingdom a peak rate close to 5% is expected in September or October. In the United States inflation could reach a high point above 6%.
If oil and food prices stop rising, then the inflation news should improve, gradually, from the fourth quarter onwards. However, forecasters have been assuming that oil and food prices will stop increasing for some time, and there is no sign yet of it happening. Primarily, this is because demand growth in emerging economies remains strong and supply is unable to cope. Only when emerging economies slow down, which may not be until 2009, will inflation fears start to ease.
In the meantime, there is a risk that inflation becomes entrenched. This would happen if workers look for larger wage settlements to compensate for higher food and energy prices and businesses grant higher settlements and pass the costs on in the form of higher prices. So far, there is no sign that this is happening, but the longer recorded inflation stays high, the bigger the risk. It is fair to assume that central banks would respond to larger wage settlements by raising interest rates, so increasing the chances of a recession in 2009.
The global economy, and the European economy in particular, could come close to recession in 2009 in any case. Leading indicators already point to a period of very weak output growth. High interest rates, the strength of the euro, slower overseas demand and high oil prices are all likely to prove significant headwinds to growth over the next year or so.
High inflation and weak growth – called stagflation by some – is the worst combination for equity markets. However, it is not that unusual. In a normal economic cycle, inflation lags real economic activity. As a result, there is usually a phase when output growth has slowed but inflation is still rising, reflecting an earlier period of strong output growth. This is the phase of the cycle that we are in right now. If this is a normal cycle, inflation pressures will ease in 2009 and central banks will be able to relax monetary policy. This should lift some of the pressure on equity markets.
There may then be scope for equity markets to rise. One factor that could boost them is valuation. On standard measures used in financial markets, like the price/earnings ratio based on analysts’ estimates of where earnings will be in 12-months time, equity markets already look cheap. The worry is that, while the economic situation is deteriorating, earnings estimates will be cut, so markets may not be as cheap as they seem. However, once the economic picture appears to be improving, earnings estimates should start to be revised up. In that environment, valuation should underpin gains in equity prices.
Unfortunately, that is not likely to be until later this year, and perhaps not until 2009. In the next few months, worries about inflation, economic growth and the financial system are likely to dominate. This is not good news for equities.
Conclusion
Financial markets in the first half of the year were hit by a ‘perfect storm’ of bad news: troubles in the financial system, slowing economic growth, downgrades to corporate earnings, higher inflation and the prospect of rising interest rates.
In the next few months, the news flow is unlikely to improve much, if at all. So financial markets are likely to remain volatile and there is a risk of new lows for equity prices.
However, the bear market is already advanced and equity markets appear cheap. If this is a normal cycle, inflation fears should ease towards the end of the year, creating scope for interest rates in Europe to come down in 2009 and setting the scene for a revival in economic growth. At some point, equity markets should recover in anticipation of such an outcome.
The second half of the year will not be easy for investors, but it could turn out to be less bad than the first half.
Tony Dolphin, Director of Economics and Strategy, Henderson Global Investors
• As expected, the European Central Bank (ECB) increased interest rates in the Euro-zone by 25bp last week, lifting them to 4.25%.
• The ECB has made it clear that it is worried current high inflation rates will lead to a general rise in inflation expectations and wage settlements. If this occurs, there is a risk that inflation in the Euro-zone gets stuck at a permanently higher rate.
• The ECB has gone out of its way to emphasise that it does not see this move as the start of a series of rate hikes, but there is little doubt that it would act again if it felt that inflation expectations had not been sufficiently damped.
• Euro-zone inflation for June hit 4.0%, its highest level since the beginning of the monetary union and 2% above the ECB’s target rate.
• As with most of the world’s inflation, the main contributors have been food and energy. Core inflation remains at a relatively subdued 1.7%.
• But the ECB remains concerned with the potential for pass through into higher Euro-zone wages. Based on the lagged relationship between resource utilization and headline inflation, the latter is set to remain elevated around current levels until at least the end of 2008.
- A week after the ‘retail sales print heard ‘round the world’ the Confederation of British Industry released its monthly survey which showed that UK retailers’ confidence continued to slide in June.
- ‘Sales for the time of year’ improved slightly to -21 from -25 in June but expectations deteriorated to -7 from 6 in the same period.
- The volume of orders placed to suppliers also improved in June from -23 to -12 but, once again, expectations for July eased from -2 to -13.
The balance of data points to a slowing in retails UK retail sales volume growth to 1-2% y/y in the coming months.
- The eurozone’s composite purchasing manager’s survey fell below the key 50 boom/bust line for the first time since October of 2003.
- The survey was dragged lower by softer than expected activity in France. The French manufacturing and services PMI’s both dipped below 50 to 49.2.
- The Italian and Spanish PMI’s have shown growth contracting for a number of months which means that Germany is the only economy still experiencing positive economic momentum, according to purchasing managers.
Our model is now calling for Q3 GDP growth somewhere in the 0.7%-1% y/y range.
- French consumer spending came in a stronger than expected 3.1% y/y in May, up from 0.2% the month before.
- Despite the strong number, various consumer confidence indicators including the GfK, European Commission, INSEE and ISAE continue to point to sluggish consumption growth in the Eurozone.
- Real disposable income growth has slowed from a peak of 3% y/y in Q107 to 1.5% in Q407 and will likely be lower in the first quarter of this year due to the sharp rise in inflation thus far this year.
Despite growing headwinds for the European economy, the ECB is more likely to hike interest rates due to stubbornly high inflation.
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