Two-way stretch

The double curse of slowing growth and rising inflation threatens to blight the economy as the American slowdown kicks in. Can central banks in the West cut interest rates sufficiently to reinvigorate their economies? Simon Hildrey reports.

The ice was here, the ice was there,
The ice was all around:
It cracked and growled, and roared and howled,
Like noises in a swound!

The investment world is much like this scene surrounding the sailors in Samuel Taylor Coleridge’s poem. Everywhere you look there is despair and gloom.

There has been a run on one of the largest banks Britain, the European Central Bank has had to inject liquidity into inter-bank markets, financial institutions are writing down billions of pounds on subprime losses, banks have imposed tighter lending criteria, the Bank of England says the credit crunch will hit British economic growth hard next year and America’s Federal Reserve has reduced its economic growth forecast for 2008 from a range of 2.5% to 2.75% down to 1.8% to 2.5%. On top of all this, 40% of Americans expect a recession.

The Fed says it has cut its growth forecast because of several factors, “including the tightened terms and reduced availability of subprime and jumbo mortgages, weaker than expected housing data and rising oil prices”.

It is primarily concern about the impact of the credit crunch and falling house prices on the American and global economies that is behind the fear and despair. This is reflected in the continuing volatility in stockmarkets. On November 19 there were steep falls across markets. These included the FTSE 100 ( down 2.71%), FTSE 250 (down 3.36%), FTSE 350 (down 2.80%), FTSEurofirst 300 (down 2.10%), S&P 500 (down 1.75%) and Nasdaq (down 1.66%). On more than one occasion the Hong Kong market has fallen more than 4% in a day.

Performance data for the past three months are good. The Topix is the only major index with a fall – of 0.04% – over three months to November 19, according to Morningstar. Indices with positive returns include the FTSE 100 (4.34%), FTSE All Share (3.69%), MSCI Asia Pacific (11.83%), MSCI Emerging Markets (24.33%), MSCI Europe (2.98%), MSCI World (2.79%) and S&P 500 (1.37%). The S&P 500 hit a record high in September. But the past five weeks have seen negative returns across markets, reflecting the downturn in sentiment.

So far, economic data in America is positive. But there is a widespread belief that the economy will turn down during the fourth quarter and into 2008. In considering the outlook for the global economy and stockmarkets, there are three crucial questions. The first is the degree of the economic slowdown in America. Will it slow to between 1% and 2% or head into a full-blown recession? Estimates are impossible because no one knows the full impact of the credit crunch and the full exposure of institutions to subprime defaults.

Second, will inflation imported into the West, primarily from oil and soft commodities, restrict the ability of central banks in America and Europe to reduce interest rates sufficiently to reinvigorate their economies? This could lead to the threat of stagflation, in which there is slowing economic growth and rising inflation. In other words, central banks will be stuck in a difficult position.

Third, to what extent can emerging markets take up the slack from the predicted economic slowdown in the West? To what extent is growth in emerging markets being driven through internal and intra-regional demand?

There has been much talk about the decoupling of Asia, in particular, from America. This is a bit of a misnomer because global integration is stronger than ever. More pertinent is the degree to which emerging markets have grown so that the world is less reliant on American consumer spending.

The bearish view is straightforward and persuasive. Tim Price, director of investment at PFP Wealth Management, is firmly in this camp, saying that stockmarket conditions are the worst he can remember for 16 years.

Easy credit has come to an end. Even though America has started to reduce rates and Britain is expected to follow suit in December, the cost of borrowing has risen for businesses and individuals. Bears say this, along with tighter lending criteria, will reduce corporate investment and consumer spending.

The fall in house prices and defaults on mortgages in America will also hit consumer spending. Paul Ashworth, an economist at Capital Economics, does not see the housing market as even close to bottoming out. Even though house starts rebounded by 3% to 1.23m in October, this only partly reversed the 11.4% decline in September.

Single-family starts fell from 954,000 to 884,000 in October and the number of building permits declined to a 14-year low of 1.18m.

Ashworth says this indicates that the number of house starts will fall again over the coming months. “Even if starts did somehow miraculously stabilise over the next few months, the overall level of housing construction would still continue to decline for at least another six months because of the time it takes to build a home,” he says.

Price says an American recession is already a “done deal”. This is partly because consumer spending accounts for about 70% of American GDP and Price argues that this will decline, given the above factors.

Tony Dolphin, director of economics and strategy at Henderson Global Investors, says it is a 50-50 call on whether America will fall into recession. “Economic growth in the US has been driven by the appreciation in house values, but they are now falling,” he says.

Trevor Greetham, director of asset allocation at Fidelity International, says the best environment for equities is when earnings and profits are rising and interest rates are stable or falling. “At the moment, we are in almost the reverse situation.”

There is growing concern that these factors will bring down economic growth in Europe as well. “The credit crunch is convulsing the financial world and is a major threat to US and European economic growth in 2008,” says Charles Dumas, an economist at Lombard Street Research, the consultancy.

Ian Kernohan, an economist at Royal London Asset Management, says the consensus forecasts for economic growth in America, Britain and continental Europe have been reduced over the past few months. Yet Kernohan says the decline in sentiment has not gone far enough. “We are forecasting slower economic growth than the consensus,” Kernohan says. “The biggest risk of a recession in the US will come in the first half of 2008, when we expect economic growth to be very weak.

“There will be a slight improvement in the second half of 2008 as the fall in house prices slows.”

Kernohan is forecasting growth of 1.8% in America in 2008. “This is not a recession but it is still weak growth. The consensus forecast for growth is now 2.3% compared to 2.4% last month and 2.6% six months ago.” This compares with American growth of 2.6% in the third quarter of 2007. The eurozone also delivered reasonable growth of 2.98% in the third quarter.

The extent to which sentiment is deteriorating is shown by Britain, where the economic slowdown is less mature than in America, says Kernohan. As recently as August it was widely expected that the Bank of England would raise interest rates. Now the consensus is that rates will be cut in December.

This is despite the fact the British economy grew at a year-on-year rate of 3.3% in the third quarter of 2007. It was the strongest such growth since 2004. But several sets of data point to a slowdown in the fourth quarter. These include falls in the Purchasing Managers’ Index (PMI), retail sales and mortgage approvals. “We are in line with consensus forecasts of 1.9% for the UK for next year,” says Kernohan. “Three months ago, consensus forecasts were for growth of 2.2%.”

Kernohan expects equities to suffer falls over the next month or two. “We have not reached the stage where most investors are pessimistic,” he says. “We are getting there but are not there yet.” But Kernohan admits that if the FTSE 100 falls below 6,000 points, it will look more attractive to investors.

Even a bull such as Mike Lenhoff, the chief strategist at Brewin Dolphin, says he is cautious about the near term outlook. But Lenhoff stresses he is not bearish. “People who have invested in equities over the past four years have done well,” he says. “They have done even better if they have been invested in mining stocks and emerging markets. Therefore, it is logical they should consider taking some of these profits, given the uncertainty surrounding the economy and stock markets.”

According to Lenhoff, the recent volatility represents a pause in the bull market. “I believe the market will stay within a trading range in the short term.” This range will be from about 6,000 points up to about 6,600 points for the FTSE 100.

Lenhoff says there are factors that will provide a cap and a floor to this trading range. The cap will be provided overblown earnings expectations being downgraded.

The floor will be supplied by two factors, says Lenhoff: the realistic valuations of equities and the likelihood that central banks will cut interest rates.

“We are not in the same situation as in 2000,” says Lenhoff. “Seven years ago, interest rates were rising and equity valuations had gone too high. Interest rates are stable or falling and valuations are not a problem. Even allowing for earnings downgrades, valuations are acceptable even if they are not cheap.”

After the past few weeks of volatility, Lenhoff says technical indicators suggest that the British equity market has been oversold to a greater extent than at any other time during the past two years. “In August, the FTSE 100 fell to 5,850 points. The markets may test these levels again. If the FTSE 100 fell below this level then I would be concerned.

“There is a lot of uncertainty and only one way of responding. We expect the Federal Reserve to cut the Funds rate on December 11.

“A quarter-point cut is on the cards but the Federal Reserve may even cut by a half-point, a prospect that is not being discounted in the futures market, but may be as decision time draws near. We think the [Bank of England’s] Monetary Policy Committee in the UK may shave the base rate by a quarter-point at its December meeting.”

Bulls argue that equities have been de-rated over the past few years because profits in Britain have outperformed equity valuations while corporate balance sheets are relatively strong. The weak point of this argument is that an economic slowdown will reduce earnings and corporate profitability.

Another threat to optimistic scenarios comes from inflation and currency movements. The oil price has been threatening to break through the $100-a-barrel barrier, while the price of food and commodities has been rising. The oil price has almost doubled since being $50 a barrel at the start of 2007.

Kernohan says an economic slowdown is normally the best medicine to reduce inflation. “But if inflation is being imported then an economic slowdown in the West may not achieve this,” he adds.

Gabriel Stein, an economist at Lombard Street Research, says American policy making over the next two to three quarters “will become more difficult as weaker household spending and hence output growth competes with higher inflation for the correct action”.

He adds that since the Fed announced it will attach greater significance to inflation, November’s inflation release from the Bureau of Labor Statistics may take on more importance. “While the core rate was unchanged at 2.1%, the headline rate jumped to a year-high of 3.5%,” says Stein.

“Had it not been for a 0.1% fall in the headline CPI [Consumer Price Index] in August, which was mainly due to lower oil prices, the 12-month rate would have been even higher. As it is, if we assume the monthly change remains at 0.3%, as it was in September and October, the 12-month rate this month will rise to 3.8%.

“This may be too pessimistic as oil prices have barely moved in November. But even at current levels the headline inflation rate is uncomfortably high. It is enough to again raise a question mark over the Federal Reserve’s decision to cut interest rates on October 31.”

However, Stein, also points to a rise in retail sales in October of 0.2%. This means real retail sales fell in October. He says weak sales in November and consequently in the fourth quarter, would justify the cut in rates at the end of October. But he adds that the “higher inflation means there is now a real danger the Federal Reserve in the near future will face the unwelcome twin spectres of stagflation”.

Nevertheless, Stein says stagflation should not last too long. “The US operates with a negative output gap of between 0.5% and 1%. Inflationary pressures are mainly the consequence of the weak dollar and rising commodity prices,” he says. “While dollar weakness is likely to continue, commodity prices should ease next year, assuming the Chinese authorities manage to halt their overheating. Nevertheless, over the next two to three quarters, the Federal Reserve may find its policy making more difficult than has been the case.”

This is because the rate of inflation may prevent America from reducing rates by the amount required to stimulate the economy. Lenhoff, however, argues that central banks will cut rates to avoid recession and worry about the headline rate of inflation later. He adds that slowing economies in the West will be sufficient to restrain inflation.

The weakness of the dollar and currency movements could have a significant effect on economic growth and stock markets. The weaker dollar, for example, has been boosting American exports. Kernohan, however, says that exports will have to grow more than imports to offset slower growth in consumer spending.

In contrast, the euro has been strengthened as assets have been diverted from America to Europe. This will hit exports from Europe.

Those countries with currencies pegged to the dollar, such as Hong Kong and the Middle East, have to reduce interest rates in line with America. The danger, says Mark Mobius, head of emerging markets at Franklin Templeton, is that inflation in such countries is driven higher.

“Dubai is talking about being pegged to a basket of currencies rather than just the dollar,” says Mobius. “Other countries will have to look at doing the same or inflation will get out of hand.”

Mobius concedes that such moves would probably weaken the dollar further. But he says this will boost American exports and thus benefit the economy.

The other question is whether emerging markets can maintain their growth in the face of a slowdown in America and Europe. The common answer is that it depends on the degree of the slowdown in America.

Capital Economics says that while the performance of Asian economies will be tested by an American-led global slowdown over the next year or two, their track record is encouraging, particularly in 2001 to 2002. The research consultancy says this resilience was in part because Asia had already gone through a major downturn of its own after the regional financial crisis of 1997 to 1998. Both these periods, adds Capital Economics, show how one part of the world can weather economic shocks in another part.

Capital Economics says the relationship between Asian exports and American GDP is also comforting. Asian exports to America fell in 2001 and 2002 but overall GDP growth in Asia held up during these two years.

“We are not expecting such a severe slowdown in the US this time around,” says Capital Economics. “Admittedly, a handful of smaller countries are highly exposed, particularly Malaysia and Singapore where US-bound exports account for more than 20% of GDP. But the countries least reliant on the US are also the regional powerhouses, notably Japan, China, South Korea and India. This is further reassurance that, provided America avoids an outright recession, Asian economies and investors should not have too much to fear.”

The sailors in The Rime of the Ancient Mariner followed the albatross to safety but then killed it and suffered from a curse for doing so. Investors will be hoping economic prosperity in the future will not have been killed by the greed of some.

IMF downgrades global growth forecast
The International Monetary Fund (IMF) has downgraded expectations for growth for 2008, but they are still relatively high by historical standards.

The IMF forecast was for global economic growth to be above 5%. But Rodrigo de Rato, managing director of the IMF, says that because of the crisis in the credit markets and the downturn in the American housing market, it has downgraded the forecast to 4.8%.

The IMF is projecting growth of 1.9% in America, 2.1% in the eurozone and 1.7% in Japan.

“In Europe, tighter credit conditions and slower export growth are the main reasons why our expectation of growth has diminished,” de Rato says. “Japan has been less directly impacted by financial disruptions, but weaker external demand for its products and some softness in domestic spending, particularly consumption, are expected to slow growth.”

But the IMF expects growth in emerging markets to remain strong. “China and India will be substantial contributors to global growth this year,” says de Rato. “In fact, if you were to measure economies in purchasing power parity terms, they would be the largest contributors to global growth. And we would expect this to continue in 2008.

“In Latin America, the pace of activity is likely to moderate slightly in 2008, partly reflecting spillovers from the US, but strengthened policy fundamentals should limit the impact of market turbulence.

“In Emerging Europe and the CIS [Commonwealth of Independent States] countries, we expect growth this year to remain close to last year’s pace, although some countries that have relied heavily on large-scale bank inflows may be more affected by fallout from the recent financial turmoil.

“In Africa, the near-term outlook remains positive, with growth this year and next expected to be about 5.5%.”

Despite this relatively optimistic prognosis, de Rato says downside risks to growth are much higher than six months ago. “The main risks are further disruptions in financial markets and a possible weakening of asset prices, especially house prices,” he says. “Globally, a combination of financial market problems and falling asset prices could lead to a loss of confidence, which in turn could have an adverse impact on economic activity. And if there is an economic downturn, other risks already present will loom larger.

“Emerging and developing economies have so far not been directly affected by the turbulence in the credit markets. But even the fastest-growing economies would not be immune to a generalised downturn in advanced economies that reduced their import demands. Some emerging economies are also more directly at risk.

“We see some pockets of vulnerability, especially in Eastern Europe, among countries that have relied on external financing to fund large current account deficits and credit booms. If these countries also face reduced demand for their exports and tighter financial market conditions, it could tip them into crisis.”

The IMF says high oil prices have not so far had much of an impact on global activity and inflation. But it adds that the recent spike in the oil price will probably push up headline inflation over the next few months. “The direct effect of the oil price rise on headline inflation in the US is estimated to be about 0.5% by the end of the year,” it says. “Central banks may find they have less room for manoeuvre in responding to weakening demand caused by the financial turbulence, given that higher fuel costs could have second-round effects on other prices and on wages.”

“The situation is particularly challenging in some emerging markets where overheating pressures are of greater concern and rising fuel and food costs may put pressure on household budgets and external balances. In particular, for many low-income oil-importing countries, the recent oil price increase will raise their import bill and could put a strain on fiscal positions.

“Assuming that strong GDP growth continues in emerging markets, high and volatile oil prices could become the norm for some time.”