To say that the first half of 2008 was a volatile environment for investors is somewhat of an understatement. Looking forward we can’t help but wonder what the future may hold. In the second half of 2008, global growth is likely to slow further, although inflationary pressures may remain elevated for a while longer before trending lower. There are several key macro themes that could be critical to market performance in the next six months: renewed pressure on the US consumer; continuing cycles of losses and injections in the banking sector; clearer signs of slower growth in Europe; global inflation to be less of a concern, although commodities remain an upside risk; and softer growth and lower inflation in China (this will caused by a combination of slower and a strengthening currency). While global growth is expected to slow over the forecasting horizon, inflationary pressures are likely to be slower to recede. As such, the next few months will likely remain a challenging environment for policymakers and there is a risk that some EM central banks remain behind the curve.
Now I shall delve further into the six macro themes for the second half of 2008.
Renewed pressure on the US consumer. Despite strong headwinds, including plummeting consumer confidence,
US consumers in the first half of the year continued to spend and overall growth has been stronger than expected. This consumer resilience is evident in the very strong retail sales report for May. This most likely reflects the impact of tax rebates, which have boosted spending a bit sooner than previously expected. But, the fiscal stimulus would only be a temporary boost to consumer incomes and the headwinds facing the consumer would re-impose themselves later this year. Besides higher energy prices and tightening financial conditions, US consumers are faced with the ongoing deterioration in the housing market, weaker jobs and income growth, falling equity wealth and a US banking sector that is increasingly hesitant in extending any form of lending. Unless the recent drop in oil prices continues and/or there are additional tax cuts, expect the consumer spending data to slow meaningfully over the next few months. Although the trade sector continues to provide a boost to the economy, this profile for consumer spending is likely to experience a double-dip, with GDP growth likely to be anemic towards the end of this year and the first half of 2009. Expect further USD weakness and a steeper yield curve. Equity market consumer views appear rich relative to macro benchmarks, and with the economic data set to worsen further, the fundamental story here still has plenty of room to play out.
Continuing cycles of losses and injections in the banking sector. The fear of a systemic collapse of the US financial sector has been at the top of the market’s and policymakers’ list of concerns since last summer. With many US and European financial sector companies entering the current housing and economic downturn with highly leveraged balance sheets, the overriding concern of investors since last summer has been the fear of further write-downs and falling earnings expectations. So far banks have been successful in raising additional capital but their ability is arguably likely to become impaired given the recent price action, which has seen financial stocks shed 14.2% over the past two weeks (and down 40.7% year to date). Moreover, it is reasonable to expect policymakers to remain alert to the need for additional liquidity and capital injections as confidence in the financial system continues to come under pressure. Last week’s equity meltdown of the US housing agencies Fannie Mae and Freddie Mac was reminiscent of the suddenness of the Bear Stearns demise in March, and highlighted the precarious position of those institutions that are directly exposed to the dynamics of the US housing market at the current juncture. The latest episode led to the US Treasury and Fed announcing measures to extend credit to, and buy equity in, Fannie Mae and Freddie Mac, if requested by the two GSEs, thus allowing them to remain active in the troubled mortgage market. This cycle of losses in financial institutions, and associated swings in confidence and liquidity injections from the authorities, could remain a feature of the outlook in the second half of 2008—especially if the US housing market continues to deteriorate.
Clearer signs of slower growth in Europe. As the US economy continues to slow over the next few months, growth in the BRICs and the EM universe should moderate only gradually, and their resilience should help to keep global growth reasonably strong. But it might become clearer in the second half that growth in the advanced economies is slowing. The latest Euro land industrial production data (-1.9%mom in May) and PMI surveys suggest that growth is slowing from the very strong first quarter. Indeed, tighter financial conditions (mainly due to the stronger Euro and higher interest rates) and rising oil prices pose meaningful downside risks to Euro land growth in H2. One area that looks particularly vulnerable is the Euro land consumer. Consumer confidence has fallen to its lowest levels since 2003. Consumer-related data in France is weakening, similar to Spain, reflecting to some extent a slowing housing market. Signs of economic weakness are also emerging in other English-speaking economies. The most striking signs of economic trouble are in the UK where falling house prices, tighter credit conditions, weaker global demand and a squeeze on household disposable incomes all suggest mounting risk of a recession. Tightening financial conditions are also slowing growth momentum in Australia, while the main driver of the New Zealand slowdown is an entrenched capitulation in the residential property market.
Global inflation to be less of a worry, but commodities are a wild-card. Global inflation could still rise further, but it could begin to fall off later this year as growth slows and base effects from food and energy prices start to kick in (assuming that the prices of food and energy stabilize). The recent drop in oil prices will be important to monitor in this regard. The rise in inflation has been more evident in the EM space relative to the developed world (where rising inflation expectations are perhaps more concerning). EM inflation has risen from a low of 4.8% in late 2006 to current levels of 9.1%. There is a chance that EM inflation peaked in 2008Q2 and one could expect the downward trend to continue until end-2009. The main driver of this forecast is the view that commodity price inflation (both food and energy) is likely to slow from current levels, leading to favorable base effects. The main risk to this view is if commodity and energy prices continue to accelerate, and this in turn keeps upward pressure on headline inflation intact in various countries. Physical shortages for many commodities, together with strong emerging market demand, suggests the risk still lies to further upside price risk in the near term. In addition, the risk of second-round effects materializing also rises significantly if near-term headline inflation continues to rise.
China: Softer growth, lower inflation. China will experience a moderate slowing in growth (but with consumption remaining strong) and a marked fall in inflation. This will primarily be due to the global slowdown and a strengthening Yuan. In its pursuit of lower inflation, China’s currency adjustments will take on a larger role in tightening monetary conditions this year The expected fall in Chinese inflation would obviously relieve current global and EM inflation fears, and likely be a boon to investor sentiment and Asian equity markets in particular.
Global central banks walking a tightrope—the risk is that some are behind the curve. Global central banks will have to tread carefully over the next few months in their attempt to keep inflation (and inflation expectations) under control. Applying too much pressure on the brakes would risk growth prospects. But not doing enough would fuel inflation concerns. The ECB did not seem to be overly concerned about braking too hard when it raised rates 25bp this month. But, judging by the accompanying statement following this hike, ECB will likely remain on hold during H2. In the absence of inflation expectations becoming unanchored, the Fed is also unlikely to raise rates either. The market has certainly moved in this direction, with just a 13.5bp hike now priced in by the end of the year compared with nearly 72bp in mid-June. The higher than expected +1.1% and +0.3% rise in June headline and core CPI respectively is a timely reminder of the inflation risks. Given the macro headwinds the UK economy is currently facing, there is some chance of further UK rates, the market is currently pricing in a 40% chance of a rate hike by year-end. Turning to the emerging markets, some EM central banks have been more proactive in counteracting rising inflation expectations than others. Among the major EMs, Brazil and Mexico have generally taken a fairly aggressive stance and even in those countries, where the central banks initially appeared to be behind the curve, interest rates are now being lifted. For instance, last week, the Russian central bank raised rates by 25bp and also allowed the currency to appreciate. Moreover, the Reserve Bank of India has responded to soaring WPI inflation by recently raising rates and the cash reserve ratio. In contrast, in other EMs, such as the Philippines, Taiwan, Hong Kong and some Middle-Eastern economies, inflation appears to be turning into a broad based problem and central banks are still behind the curve. Of course, in NJA, countries with large BboP surpluses and undervalued currencies (such as the MYR, CNY, TWD or SGD) are still able to use their exchange rate in order to fight inflation. From an equity standpoint, countries with positive exposure to the near-term upside risk to commodity prices (such as Brazil, Russia, and Mexico) will remain at a relative advantage compared with markets such as India and Turkey, which have negative exposure to commodities and are also experiencing macro headwinds generated by policy tightening.