Will a cooling American housing market lead to weaker demand among American consumers next year, and ultimately a slowdown in global growth? Or will other countries take up the slack? Simon Hildrey reports.
In the new Casino Royale Ifilm, James Bond has a battle of wits with the villain over a game of poker. Bond thinks he knows when the private banker is bluffing but the banker is trying to double-bluff him.
Central banks are faced with a similar dilemma. They are involved in a constant game of nerve and timing, never more so than now after a period of interest rate rises in much of the developed world. Central banks have to manage the dilemma of not raising rates too high in case it damages economic growth, while also not reducing rates too early in case it stokes inflation.
Many strategists and fund managers do not believe the dilemma for central banks is particularly great at the moment, however. There is a widespread expectation that global economic growth will slow in 2007. This will be led, so the argument goes, by weaker consumer demand in America following a slowdown in the country’s housing market. This will have a knock-on effect for the rest of the world, although the common belief is that this will not lead to a drastic slowdown.
Henderson Global Investors, for example, expects GDP growth in the world to fall to 4.5% in 2007 from 5.1% in 2006. The biggest fall will come in America, Henderson says, from 3.6% to 2.5%.
This is not sufficient, however, to deflect most fund managers from their optimistic view of equities and the global economy. This optimism is boosted by a belief that interest rates in Britain, America and Continental Europe are at or close to their peaks.
John Chatfeild-Roberts, head of Jupiter’s independent funds team, argues that “inflation is under control, US leading indicators are buoyant, Chinese growth is still around 10% a year, there is plenty of liquidity around the world, especially in oil-producing countries, and growth companies look undervalued”.
Chatfeild-Roberts is sanguine about the housing market in America. He points out that about 90% of mortgages in America are fixed. “Furthermore, the floating mortgage rate never declined as low as 1% but was closer to 4%. It is now around 6-7%, so the magnitude in change has not been as great as some imagine,” he says.
David Shairp, global strategist at JPMorgan Asset Management, argues that the global economy is in the mid-cycle of a period of global growth. Therefore, he expects growth to strengthen again next year. “The current mid-cycle correction will probably only last two or three quarters, although it may take a few quarters for the housing slowdown to halt,” Shairp says.
He adds that the housing slowdown will fail to derail the growth in the American and global economies. “There will be an impact on consumer spending but there will be a pick-up during the next year,” he says.
Shairp points to the fact that the International Monetary Fund has predicted the global economy will grow by more than 4% in 2006 for the fourth consecutive year. He says corporate profit growth in 2007 may slow down to 6-8%, “but this is a good result at this stage of the business cycle”.
“This would be sufficient for equity markets to continue to perform strongly,” he adds. “We do not believe equity valuations are looking stretched. The US looks the most attractive market. Models suggest there will be an internal rate of return of 6% from equities for all the major markets.”
The optimism has been supported by the performance of equities following the market correction in May and June. Since then, all the major stockmarkets have recovered, with the exception of Japan. Between May 15 and August 14, according to Standard & Poor’s, Britain, Japan, America, Continental Europe, Asia Pacific and emerging markets all delivered negative returns.
But from August 14 to November 13, the FTSE All-Share (up 8.67%), MSCI Emerging Markets (9.29%), MSCI Europe ex UK (12.02%), S&P 500 (8.61%) and S&P/Citi BMI Asia Pacific ex Japan (10.06%) all made positive returns. The two exceptions were Japan TSE 1st Section Topix (down 1.36%) and S&P/Topix 150 (down 0.06%).
There is no consensus on the factors behind the spring correction in stockmarkets. One argument is that the Bank of Japan’s withdrawal of liquidity in March and the expected rise in interest rates from zero to 0.25%, which did happen in July, shook investors. There was concern there would be an unwinding of the carry trade in which investors borrowed in yen to invest elsewhere in the world.
Other unsettling developments in the spring and early summer were the high oil price, rising interest rates and the conflict in Lebanon. The subsequent stockmarket recovery has been helped by the falling oil price, expectations that interest rates are near their peak and the end of the conflict in Lebanon.
It is argued that a major contributing factor has been global liquidity driven by the cheap cost of borrowing money. This has been most clearly demonstrated by the never-ending wave of takeover activity. It is estimated that mergers and acquisitions around the world will be worth $3.47trn (£1.8bn) this year. This would exceed the $3.33trn in 2000 and every year since.
Many strategists and fund managers also argue that attractive valuations have supported markets despite the strong returns in equities since March 2003. Indeed, Mike Lenhoff, chief strategist at Brewin Dolphin Securities, says the American market is cheaper now than it was in March 2003 on price/ earnings measures. According to Henderson Global Investors, the P/E multiples of America, Japan, the eurozone and Britain are all lower in 2006 than in 2005. America, for example, is on 16.1 times and Britain is on 14.2.
Lenhoff says that while valuations are supportive for stockmarkets, “the key to the future is your view of corporate earnings. If they fail to meet expectations then stockmarkets will suffer.”
He adds that the American stockmarket has been supported by corporate earnings beating analysts’ expectations. “Analysts’ expectations for earnings in America on July 1 for the third quarter were 15.3%,” he says. “With most of the S&P 500 companies having reported, year-on-year growth is almost 19%. This has been the trend for several quarters.”
Craig Heron, a fund manager at New Star Asset Management, however, says the American economy is currently in a precarious position. “There are three schools of thought about the outlook for the US economy,” he notes. “First are those who believe in the goldilockseconomy. This is a belief that there will be a soft landing in the US. They expect GDP growth to rise in the fourth quarter by between 2% and 2.5%, along with double-digit profit growth.
“Second is the no-landing theory. Supporters believe the third-quarter growth of 1.25% to 1.5% was an anomaly. They expect economic growth to be 3% to 3.5% next year. They believe consumer spending will hold up and corporate expenditure will pick up. This would mean the Federal Reserve would have to raise interest rates.
“Third is a hard landing. This would see the housing slowdown feed through to a decline in consumer spending.”
Heron says his view is that there will be somewhere between a soft and a hard landing. “If there continue to be few inflationary pressures and the housing market does not recover then the Federal Reserve is likely to cut rates quickly in the new year,” he says.
This optimism should not detract from the fact there a number of risks to the global economy. Some economists believe the American housing market poses more of a threat than described above, for example. Paul Ashworth, senior US economist at Capital Economics, says: “Despite claims from the optimists that the housing market is stabilising, we still see things getting worse for some time to come.
“Housing starts dropped below 1.5 million on an annualised basis in October and permits fell sharply too. That suggests residential investment is still contracting sharply.
“Whether sales now stabilise has little bearing on our view that the housing slowdown will have a big impact on the wider economy. The contraction in residential investment and homebuilding is already well under way and the lagged impact on consumption depends on prices, not sales. The news there is worrying. The only reason sales appear to have stabilised is that sellers are willing to slash prices to attract interest.”
One of the risks to equities comes from inflation in America, Lenhoff says. “Our view is not that this will happen but it is a risk when a while ago we thought rates would definitely come down,” he adds.
“The inflationary pressures come from two areas. These are the labour market and productivity. Unemployment is at the low end of the historical range and therefore wage growth has been accelerating. At the same time, productivity growth has been slowing down. This has led to a rise in unit labour costs that the Federal Reserve has been keeping an eye on. Unit labour costs were flat for a few years but have jumped from zero in 2004 to 5% growth now.”
Lower energy costs will boost consumer spending, Lenhoff says. With unemployment at low levels, this is likely to push up unit labour costs further, and therefore inflation as well. The danger of a rise in inflation, of course, is it could prompt higher interest rates, which in turn may stifle economic growth.
Roger Bootle, managing director of Capital Economics, argues that the widespread assumption that if an economy slows then inflation will naturally fall back could prove to be misplaced. He says in the current economic conditions, growth may ease and unemployment rise with “next to no impact on domestically generated inflation”.
“This will leave central banks with an acute dilemma: whether to raise interest rates to contain inflation or to cut them to boost aggregate demand,” he explains. “The management of expectations is especially important for the containment of inflation. Recent increases in inflation, in the context of rapid growth of the money supply and rampant asset markets, risk destabilising those expectations.
“Accordingly, central banks’ first task is to raise interest rates sufficiently to suppress those expectations. Moreover, higher rates and weaker growth may bring little or no immediate reduction in inflation. Central banks need to be prepared to sit it out. Interest rates may be kept high for an extended period.” Oil prices have risen by about 230% from trough to peak. Even with the recent falls to about $60 a barrel, Bootle says, they are still up 160% since 2003. The impact on inflation around the world has been minor, however, as it has been on slowing growth and rising unemployment. “But that does not mean there has been no impact,” Bootle says. “Inflation has moved higher just about everywhere, and in some cases rising inflation has been accompanied by higher unemployment.
“There are some worrying signs ahead. It is early days to be pronouncing the return of inflation but considering how large the energy price shock has been, mindful of what happened in the 1970s and conscious of recent rapid rises in the money supply and rampant asset markets, central banks are surely right to be concerned about the current inflation danger.”
Others are more relaxed about inflation, however. Chatfeild-Roberts says the fall in oil price has helped and there is disinflation from goods from China and elsewhere.
In Britain, the Monetary Policy Committee’s minutes for November sent out mixed signals about whether interest rates would move higher. Two members out of nine voted against the interest rate hike to 5% in November. Some have suggested this means a further rate rise is less likely. The minutes reveal the majority of members felt a rate of 4.75% was not sufficient to bring inflation down to its target of 2%.
Jonathan Loynes, chief European economist at Capital Economics, says there will be one final rise in rates early in 2007 – probably in February. This is because of inflationary pressures in the economy and capacity pressures increasing. “Thereafter, though, the downside risks to activity should ensure that rates will rise no further and, indeed, will be falling again by the end of 2007,” he adds.
Jamie Dannhauser, an economist at Lombard Street Research, says another rise is needed in 2007 because broad money growth is running at 14%, which is well above the level consistent with trend nominal output growth. This has provided upward pressure on asset prices, Dannhauser says.
One of the notable rises in asset prices is house price inflation. Dannhauser says it is currently running above 8% and estimates it will be between 10% and 15% in 2007. This is likely to translate into higher consumer spending, he argues. “With the UK economy growing above trend, inflationary pressures will continue to build,” he says. “To get inflation back to target, a negative output gap will have to emerge. Further tightening is necessary to bring this about, and hence our forecast is for rates to peak at 5.25% early next year.”
Another threat to the global economy is excess global liquidity, says Charles Dumas of Lombard Street Research. He suggests “global gluts” could inhibit recovery after 2007 and 2008. This is based on the bursting of housing bubbles, over-investment and the “Eurasian savings glut”.
Dumas says: “The household borrowing orgy and price gains of the past few years bailed out business, which has been able to restructure, holding back capital expenditure to secure positive cashflow and cut debt. But no such relief is likely as household balance sheets crumble, unless and until governments respond by raising their deficits again.
“The bursting of housing bubbles in the US, Spain, London and elsewhere will leave households required to hold down spending to rebuild assets or pay down debts.”
On top of this, Dumas says, there is a supply-side constraint on any recovery. He argues there has been over-investment in China, for example. “Optimists suggest that Asian consumer spending will gather speed,” he says. “But this seems unlikely. In the Chinese case, the best source of consumer spending is export industry workers spending their wages. That is likely to fall back, not rise.
“Structural reforms to boost credit-based household spending are not moving nearly fast enough, any more than Chinese financial reform in general.”
Tim Price, a portfolio manager at UBP, argues the biggest risk to the global economy comes from the credit markets and the quantity of M&A and private equity activity. “There seems to be little discrimination in the price that private equity managers are paying for acquisitions,” he says. “This is being driven by cheap money and there seems no end to the cheap money.
“But these deals rely on being able to turn around businesses and sell for a higher price. A sideways-moving stockmarket may not be sufficient for them to make the profit they expect. Such a scenario may lead to an unwinding of this market and have a knock-on effect.”
Conventional wisdom is that if America, as the largest economy in the world, slows then that will have a knock-on effect for every other economy. Therefore, the possibility of a slowdown in consumer spending in America following falls in the housing market and rising inflation will concern the rest of the world.
But while the American consumer has been one of the main engines behind global economic growth over the past few years, some economists and strategists believe other countries can adequately take up the slack of a US slowdown. Supporters of this view point to the economic growth in Europe and Asia, notably China, as evidence.
Indeed, Asian fund managers are keen to stress that consumer spending has been rising in the region and the continent is better able to withstand a US slowdown. This in turn would support economic growth elsewhere in the world as Asian consumers buy their exports and commodities. We may soon find out if this prognosis is accurate or whether an ailing US would lead to the rest of the world getting ill. l
IMF’s World Economic Outlook
The International Monetary Fund has upgraded its forecast for global growth to 5.1% in 2006 and 4.9% in 2007. These are 0.5 percentage points higher than its forecast in April 2006. It predicts American growth will slow from 3.4% in 2006 to 2.9% in 2007 as the housing market cools. It says growth in Japan will ease as the “cycle matures”.
The recovery in the eurozone is expected to sustain its momentum this year, even though growth is likely to be reduced through tax increases in 2007. The IMF expects growth to remain strong among emerging markets, with the Chinese economy continuing its recent rapid expansion.
It warns there are signs that inflationary pressures are edging up in some countries as “sustained high rates of growth have absorbed spare capacity”.
“Headline inflation in a number of advanced economies has for some time been above central bank comfort zones, pushed up by rising oil prices, but there are now signs of increases in core inflation and inflation expectations, most notably in the US,” the IMF says. “In Japan, there is increasing evidence that deflation has finally ended.”
The IMF says the balance of risks to the global economy is towards the downside, and there is a one-in-six chance that growth could fall to 3.25% or less in 2007. “The most notable risks are that inflationary pressures could intensify, requiring monetary policy to be tightened more than is expected,” it says. “Oil prices could increase against the background of limited spare capacity and geopolitical uncertainties, and the US housing market could cool more rapidly than expected, triggering a more abrupt slowdown of the US economy.”
Another concern is a disorderly unwinding of global imbalances. “A smooth, market-led unwinding of these imbalances is the most likely outcome, although investors would need to continue increasing the share of US assets in their portfolios for many years to allow this to happen,” the IMF says. “The depth and sophistication of US financial markets has facilitated the financing of recent large current account deficits. However, there remains some risk of a disorderly adjustment, which could impose heavy costs on the global economy.”
Central banks in developed markets face a challenge of weighing up the relative risks to growth and inflation in the future, it adds. It says the Fed has faced a difficult situation of rising inflation in a slowing economy.
“In Japan, interest rate increases should be gradual as there is little danger of an inflationary surge, while the re-emergence of deflation would be costly,” the IMF says. “In the euro area, further increases in interest rates are likely to be needed if the expansion develops as expected. But for now inflation pressures seem broadly contained and, faced with continuing downside risks to growth, policymakers can afford to be cautious in tightening monetary policy further.”
Paul Ashworth, senior US economist at Capital Economics, says while headline inflation in America declined to 1.3% in October, core inflation remained well above the “Federal Reserve’s comfort zone, at 2.7%”.
“However, over a shorter time horizon, the news on core inflation has been a little more promising in recent months,” he adds. “The three-month annualised rate has fallen back markedly through a decline in the goods and services components.”
Ashworth says falling energy prices have reduced inflation expectations. “The biggest upside risk to inflation would appear to be the rapid growth of unit labour costs,” he notes. “Core import prices should continue to decline until early next year.”
Charles Dumas, head of the world service at Lombard Street Research, however, says the falling oil price is reinforcing difficulties for the Fed. While this reduces headline inflation, it boosts real incomes by cutting the cost of living.
He adds that wage growth has been revised upwards so real incomes are growing at 4% a year, with core inflation at 2.5% to 3%. Dumas says growth in the fourth quarter of 2006 could reach an annualised 3.5% rate as business and public construction, as well as equipment and software capital expenditure, offset the housing slump.
But the growth in real income and wages is exacerbated by unemployment falling below the neutral 5.5% rate that produces non-accelerating inflation, Dumas argues. “For this neutral rate to be reached, growth has to be below 3%,” he says. “Furthermore, a housing collapse is unlikely given the real wage and income growth, and falling unemployment and oil prices.”
Therefore, Dumas adds, interest rates may stay at 5.25% until the middle of 2007, or even rise to 5.5% in the near future.
“On our assumption that the housing slump does not deal a knock-out blow, the US will get its hard landing via reinforcement of the damage to consumer confidence by the forthcoming fall in house prices, given the absolute dependence of the US expansion on increasing take-up of debt, and therefore rising asset prices,” Dumas says.
He argues this could have a knock-on effect for Asian exporters. “Net exporters are responsible for half the 10% real growth of China’s GDP and exporters’ workers spend a good bit of the 5% accounted for by domestic demand,” Dumas says. “While less than a third of Chinese exports are to the US, their progress is crucial to China’s growth.”