Sunday, November 9, 2008

Weekly Focus : Global Recession Intensifying

Economic news in recent weeks has been dismal. There are clear signs that more or less all countries in the developed world will be in recession in 2009. This is evident from among other things the steep decline in PMI data lately. We also see further indications that Emerging Markets are slowing more rapidly than previously thought. Economic news out of Asia and Central and Eastern Europe has thus been surprisingly negative lately.

The financial crisis is starting to take a very heavy toll on economic developments - in fact heavier than previously anticipated. Credit standards are being tightened significantly everywhere, and we may be close to a credit crunch in many countries. Financing costs have also risen markedly, as corporate bonds have seen sharp sell offs recently. In the US, news on consumer spending has been very downbeat, with, eg, car sales falling to the lowest level in 25 years. Consumer spending now looks set for a fall of 3-4% in Q4

Over the past week the IMF revised down its just one-month-old forecast for the global economy. IMF revised down global growth by 0.8 per. points for 2009, and now sees GDP growth in the US and Euroland at -0.3% and -0.7%, respectively. This is lower than our current forecast (at 0.0 in both US and Euroland), but we will likely revise down our own estimates in the near future. We still expect to see a recovery in 2009, but the current risk is clearly that it comes later and is slower than expected. The deterioration of growth is leading to a rapid easing of monetary policy - a picture we expect to continue in the coming quarters. We also expect to see more fiscal stimulus in the US, and a range of stimulus packages have already been announced in many European countries. The slowdown is pronounced and thus needs a forceful response.

Euroland: ECB cuts with prospect of more to come

As expected, the ECB rate-setting meeting resulted in a 50bp cut in key rates to 3.25%. The ECB also signalled that it is willing to cut rates further as early as in December. ECB President Trichet mentioned, for instance, that a 75bp rate cut had been discussed, but that the bank was unanimous in its decision to "settle for" 50bp. Given this - and the very weak activity data for Euroland recently - we expect the ECB to cut rates by another 50bp in December and 25bp in both March and June 2009. This means that the ECB will likely cut rates faster and more aggressively than anticipated in our previous forecasts of unchanged rates in December and 25bp rate cuts in January, March and June 2009. Among the past week’s very weak economic data for Euroland we find final composite PMI, which showed a decline from 46.9 in September to 43.6. Moreover, new orders in Germany have fallen sharply by 8% m/m, partly because orders for export markets shed a massive 11.4% m/m. This bodes ill for the German and hence the European economy.

Next week will be relatively light on economic data for Euroland. Tuesday will see the release of the German ZEW indicator. Consensus is for a small increase to -62, i.a. due to a rising equity market in the data collection period. Friday brings final HICP for Euroland. We expect confirmation of the preliminary data, which showed an increase of 3.2% y/y, while core inflation remains unchanged at 1.9% y/y. Provisional national accounts data for Euroland are expected to show a decline of 0.2% q/q. Consensus expects a decline of 0.1% q/q.

Key events of the week ahead

  • Tuesday: ZEW sentiment. We share the consensus expectation of a small increase from -63 to -62.
  • Friday. Final HICP for Euroland will, in line with the preliminary data, show an increase of 3.2% y/y. Core inflation is expected to remain unchanged at 1.9% y/y. Euroland GDP forecast to have declined by 0.2% q/q.
  • Other data this week: Industrial output for Euroland is released on Monday. Thursday: ECB monthly report.

Switzerland: SNB cuts by 0.5 pct. point to 2.00%

The key event of the past week was the extraordinary half percentage point interest rate cut to 2.00% by the Swiss National Bank (SNB) on Thursday. The target band for the 3M LIBOR is thus now 1.50-2.50%. The cut came between the planned quarterly meetings, but following intense pressure to cut in recent weeks and on the same day as the ECB cut by the same amount. Thursday’s cut means the SNB has lowered rates by 75bp over the past month.

The Swiss money market has seen considerable improvement over the past three weeks. The 3M LIBOR has fallen by more than 50bp, fixing on Wednesday just 10bp above the previous rate target of 2.50%, which paved the way for Thursday’s cut. The SNB has probably been wanting to ease monetary policy for some time, and would presumably have preferred to cut by more than the 25bp it delivered in connection with the globally coordinated rate cut on 8 October. However, it has been held back by the LIBOR rate remaining stubbornly above target. Nevertheless, the opportunity to cut materialised last week as the money market continued to ease, meaning the SNB could react with greater credibility to the recent pronounced deterioration in the outlook for growth and the strengthening of the Swiss franc.

The press release following the rate decision was briefer than normal. The SNB stated the reason for the rate cut was the deterioration in the global growth outlook and the subsequent impact on Switzerland’s economy. The SNB wrote that overall growth in 2009 risked being negative - presumably signalling a significant downward revision of the SNB forecast. Going forward, we expect the SNB to ease monetary policy further and we have put a total of 75bp of interest rate cuts into our forecast, with the first rate cut expected at the December meeting. However, focus must initially be on ensuring that the LIBOR rate trades down around target. The coming weeks will show whether or not the SNB will be successful on that count. The SNB also explicitly referred to the Swiss franc for the first time in some months in that it reported that the central bank would keep a watchful eye on currency developments. Thus if the Swiss franc strengthens substantially from current levels, one should consider the possibility of yet another extraordinary cut.

Market reaction to the rate cut was modest. Government bond yields fell slightly, especially at the long end, though yields remain higher than a couple of weeks ago. The Swiss franc remained stable against the Danish krone, as both the ECB and the Danish central bank also cut by 50bp. CHF/DKK is now trading just below 5 krona after having fallen back somewhat from last week’s peak on the back of an equity market that was firming until a couple of days ago.

Key events of the week ahead

  • Monday 07.45: SECO Consumer Climate
  • Thursday 09.15: Producer and import prices for October
  • Thursday 11.00: ZEW (expectations)

UK: Bank of England takes unprecedented step

In Weekly Focus last week we wrote that the UK needed rate cuts, and the sooner the better. It would seem the Bank of England (BoE) agreed with us. By cutting the Bank Rate 150bp in the past week, the BoE took an unprecedented step in fighting the economic slowdown. The rate cut took the Bank Rate from 4.5% to 3.0%. Consensus (and our forecast) was a cut of 50bp. Hence, the BoE’s move was a major surprise and indicates that central banks are ready to take extraordinary measures to fight the global slowdown.

The BoE referred to "a substantial downward shift in the prospects for inflation" due to a marked deterioration of economic activity and a sharp fall in commodity prices. It is maybe worth noting that inflation in the UK is still 5.2% (!), which clearly underlines how seriously the BoE judges the economic and financial crisis. BoE describes the financial crisis as the "most serious disruption for almost a century… money and credit conditions have tightened sharply". Formally, the BoE argues that without a significant reduction in the Bank Rate there would be a substantial risk of undershooting the 2% target in the medium term.

It was indeed a very forceful move from the "Old Lady", but the situation is also serious. The UK faces head-winds from every direction, with recession in all neighbouring countries and a credit crunch which is providing an even harder landing for the housing market. Inflation will decline sharply, and hence the BoE can focus on supporting the economy now. And it needs a lot of support! We expect the BoE to take further actions and cut rates by 50bp per month in the coming three months. This is a bit more that the market prices in, and hence we see scope for even lower yields and short sterling rates.

Key events of the week ahead

  • Monday: PPI will likely show big decline on back of lower commodity prices
  • Tuesday: RICS house price indicator expected to stay at very low level
  • Wednesday: Unemployment numbers to show further strong increase
  • Wednesday: BoE Inflation Report will paint a down-beat picture of growth, with an expectation of a rapid decline

USA: Credit crisis squeezes consumption despite energy boost

Few would disagree that the credit crisis is having a significantly negative impact on consumer spending these days. However, one might be surprised about the magnitude of the impact. We resurrected an old short-term forecasting model for consumer spending based on fundamental values such as income, inflation, house prices, equities, fed funds rate, etc. This model has worked pretty well historically, and currently forecasts around +5% q/q AR for consumer spending in Q4. The reason for such an upbeat estimate is that energy prices are now providing a significant boost to real incomes. Usually this is the most sensitive variable for consumers.

However, what the model does not include is credit effects. Usually this is not necessary, as the credit and the business cycle tend to go hand-in-hand. This time around things are different, however - we are in uncharted territory. Currently, the credit cycle is driving the business cycle. Hence, what the model below provides is an implicit estimate of the magnitude of the negative impact from the credit crunch on consumption. Thus, were it not for the credit crunch following the collapse of Lehman Brothers, consumption would have rebounded strongly by now, according to the model. This also demonstrates how difficult the current environment is to operate in and how difficult it is to exactly quantify the impact of the credit crunch going forward.

Q3 GDP data showed a 3.1% q/q AR contraction in consumer spending (the model predicted an increase of 1.4% q/q AR) and is now tracking very negatively into Q4. Retail sales data for October will be released Friday next week, and we expect it will confirm the very bleak outlook for Q4 consumption growth (see Research - US: Falling down). We expect overall retail sales to decline 2.5% m/m - as data for auto and same store sales have been very weak - and sales less autos to decline 1.3% m/m. This suggests Q4 real consumer spending is heading for an equally large decline as in Q3, which would make it the worst two-quarter performance since 1980. Other events worth keeping an eye on next week are the release of University of Michigan consumer confidence for November and Bernanke’s speech at a conference hosted by the ECB - both are due Friday afternoon.

Key events of the week ahead

  • Thursday: Trade deficit is likely to have improved in September, driven by the decline in energy prices
  • Friday: We expect a 2.5% m/m decline in retail sales in October and a 1.3% m/m decline in sales ex autos
  • Friday: Fed chairman Bernanke speaks at an ECB conference
  • Friday: We expect University of Michigan consumer confidence to decline to 56.3 in November

Asia: Slowdown intensifying in China

Asia-watchers will be focused on China in the coming week, when the bulk of the key economic data for October are due for release. In our view the numbers will show first and foremost that both export growth and industrial production growth have slowed significantly in October. We have already had an early warning in connection with the release of manufacturing PMIs for October, which showed among other things a pronounced drop in export orders in October (see Flash Comment - China: Industrial activity slowing - further easing measures announced). As can be seen in the graph below, an actual fall in real exports can no longer be ruled out in the coming months. We expect that industrial production growth will slow to 10.3% y/y in October from 11.4% y/y in September, while industrial production growth for Q4 as a whole now looks set to be single-digit. This means we will be revising down our expectations for GDP growth in Q4. At the moment, GDP growth looks set to fall below 8.5% y/y in Q4 and to below 8.0% y/y in Q1 next year. Hence, China would appear to be heading for a relatively hard landing.

On the positive side, inflation is falling faster than expected at the moment. We estimate that inflation in October will fall to 4.0% y/y from 4.6% the previous month. While it is still primarily the normalisation of food prices that is pulling inflation down, there are clear signs of inflation falling over a broad front in the wake of declining commodity prices. Administrated petrol prices in China are now higher than world market prices, so China will most likely cut here soon. We will therefore probably also cut our expectations on inflation. Previously, we had not counted on inflation going below 3% y/y in China, but this now looks like it could well be the case in 2009.

Key events of the week ahead

  • A raft of numbers in China, including consumer prices (Tuesday), industrial production (Thursday) and trade figures (during the week).
  • A relatively quiet week in Japan. Machine orders on Monday and current account on Tuesday.

Foreign exchange: What has the past week taught us?

After depressing activity data from almost all countries, indicating that we are in a global recession, a massive rate cut by the Bank of England, a horrible US employment report, Barack Obama winning the presidential election and the Democrats capturing the majority in Congress, and a few nervous days in the fixed income and equity markets in general, we now close week 45. The currency markets have been without clear direction, with sterling and the Scandinavian currencies under strongest pressure. Now the questions are: should we change our fundamental view on the FX market, and what should we expect in the coming months?

The first question is the easier one to answer: we say no, not really. We stick to our fundamental themes of global recession and a financial crisis with the now familiar ensuing currency implications. It is still too early to establish long carry positions; the currencies that correlate negatively with risk aversion are still under pressure, and fire sales, particularly from hedge funds, will reinforce this effect. Though US job cuts are rapidly deepening and economic growth is likely to remain negative in the coming quarters, the USA has nevertheless chosen the path of change. Amid the world’s misery, we still see many good reasons for being short EUR/USD (long USD/DKK) - the defensive qualities of the USD due to repatriation flows being one of the strongest reasons at this junction. Also, CHF and JPY still trade at strong levels, as we cannot yet identify a clear turning point in the financial crisis - perhaps barring the money markets.

The answer to the second question is somewhat more uncertain. While we feel certain that the developed economies overall are in recession or heading for recession and that the remainder of 2008 and at least H1 09 will see the severe economic downturn continue, we are more uncertain about the financial crisis. We expect the sum of the numerous rescue packages combined with the initiatives in the financial sector to ensure "normalisation" in the financial markets over time - though we cannot yet identify a clear turning point. Turn or no turn, we will probably have to live with uncertain financial markets, constraints to credit access, continued financial deleveraging and increased risk premiums for a while. This is obviously reflected in our currency forecast, which - as outlined above - is best described as more of what we have seen in H2 08.

The coming week kicks off with the release of inflation data for Scandinavia (Denmark and Norway on Monday, Sweden on Tuesday) as well as Danish current account data on Monday. Currency implications are limited, as the respective central bank’s attention since summer has been more on the slowing pace of growth. Activity data follows on Tuesday with the ZEW indicators for Germany and Euroland, which we expect to reflect a Europe in recession. We also expect European industrial output data (Wednesday) and German GDP (Thursday) to be affected by the slowdown in growth - something underpinned by this week’s poor orders data. A similar picture is expected in preliminary GDP estimates for Euroland (Friday). We forecast a 0.2% decline q/q. Euroland data have mostly surprised on the downside and are certainly not a reason to go long EUR. Friday will see US key data. Car sales fell sharply this week, and we expect the remaining retail sales figures to be weak; we forecast a decline of 1.3% m/m (consensus -1.0%, -0.6% last month).

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