The world economy is likely to continue to offer a benign backdrop to global markets in 2007. Indeed, there is a strong consensus in financial markets that this year will see a year of solid, if unspectacular, economic growth with fewer concerns about inflation and a peak in the global interest rate cycle. The US economy will continue to expand, albeit at a slower pace in the first half of this year, while momentum in Europe and Asia is expected to remain strong. This should allow some re-balancing of the global economy while sustaining the overall strength of the global business cycle. If energy prices remain stable then the outlook argues that investors will be rewarded for having exposure to risk – meaning that global equities in general and corporate credit markets will again perform well.
As prudent investors it is necessary to consider what might cause events to deviate from this benign path. The main macroeconomic uncertainty is, as is often the case, the US economy and how it evolves over the course of the year. It looks a though real GDP growth in 2006 will have been around 3.3%, slightly above the average of the last couple of decades. At the same time inflation remained above 3.0% for the second year. At times market participants worried about both growth and inflation. In May, equity markets corrected sharply as it appeared that inflationary pressures were building and that the Federal Reserve would have to keep on raising interest rates. As it turned out, energy prices peak in mid-year and the Fed felt comfortable enough with the underlying inflation picture to call a halt to rate increases in August. Following the summer, concerns turned to growth as it became clear that the US housing market was undergoing a considerable contraction. This resulted in a collapse in housing construction and a fall in GDP growth in the second half of the year.
Our expectation for the US in 2007 is for a soft landing. The effects of the inventory correction in the housing market will last for a while longer. In addition, the US manufacturing sector has slowed, also in response to a build up in inventories in the auto sector. This will be a drag on economic growth in H1 but should allow for the economy to pick up steam again in the second half of the year. On the positive side, the employment situation remains solid with the economy creating around 1.7mn new jobs in 2006. Furthermore, inflation fell sharply towards the end of last year.
The combination of slower growth and lower inflation means that US interest rates have probably peaked. Fixed interest markets are now pricing in some cuts in rates later this year while the equity market does not seem overly concerned by the risk of higher interest rates. Indeed, our view would be that the risks are more to the downside for the US economy. There remains the possibility that the corrections we are seeing in housing and manufacturing accelerate and lead to weakness in employment, capital spending and consumption.
For the US equity market the key concern is what happens to corporate profits. Over the last year higher energy and other input costs and rising wages have led to concerns over profit margins. Yet profitability has remained strong. It will be interesting to see how wages develop going forward. The Fed’s role in trying to control inflationary expectations is critical here. In a strange way, the longer the Fed keeps interest rates at current levels and the longer it continues to warn about the need to keep inflation under control, the better for equity markets. If the current setting of monetary policy can keep inflationary expectations and wage growth under control, then the profit cycle can continue and provide the basis for positive returns from the US stock market in 2007.
Of course, what happens in the US will be influential globally. In Europe, however, growth has continued to firm even while the US economy has been slowing down. That could very well continue in 2007, helping to correct some of the global imbalances that investors have worried about in recent years. Leading the charge in Europe is Germany which has seen positive economic data on many fronts – industrial production, exports and, more recently, consumer spending. There are numerous headwinds for the European economies in early 2007 that investors need to watch. First, there could be some knock-on effect from the slowdown in the US economy over the last six months. Secondly, there is to be further policy tightening in Europe in early 2007. The European Central Bank is likely to raise interest rates to 3.75% in Q1 while the German and Italian governments are pulling in the reins on the fiscal side. The most transparent example of this is the VAT increase in Germany that came into effect in the first week of January. It is not clear how consumers and businesses will respond to this. Some front running of the increase could have taken place on the retail sales side and some companies may choose to absorb some of the increase in taxes. It is hard to see the VAT hike not having any kind of negative impact. Another uncertainty is how the ECB will react. If there is any sign that labour unions in Germany are trying to secure wage increases to compensate for the VAT hike then the central bank might keep on raising interest rates.
We expect the Euro-zone economy to grow at a modestly slower pace this year than in 2006. However, it is not expected that growth falls back to the sluggish levels of earlier in the decade.
Japan is also looking better than it did in the first half of the 2000s. We estimate that the Japanese economy expanded by just under 3% in 2006. Exports – the traditional engine of the Japanese economy – have been strong, boosted by strong growth in the Asian region. There have also been encouraging signs in the domestic economy. Capital spending has picked up, unemployment has fallen and the banking sector looks much stronger – helped by a considerable period of extremely low interest rates. The adjustments taken by the corporate sector in recent years have boosted profits and it has been somewhat surprising in the light of this that the Japanese stock market underperformed in 2006. With interest rates remaining low, the yen exchange rate at a competitive level and the deflationary mind-set of recent years disappearing, both the economy and the Japanese stock market should do better in 2007.
Of the other major economies the picture is relatively positive. The UK is growing close to its trend rate of growth and should see lower inflation in 2007. A slowdown in the housing market will keep consumer spending relatively soft, but many parts of the UK economy are geared to the global cycle and so growth is not likely to suffer too much. Some reduction in UK interest rates could be seen as the year progresses.
In Asia, outside of Japan, China is expected to stay on course for double digit growth. The China story is clearly a secular one and the economy is on a long-term high growth path as it continually shifts population from the rural to the urban-industrial economy. The mini-cycles in China revolve around fixed asset investment with the authorities making attempts from time to time, to slow spending. Some steps were taken in 2006 but this has only had a modest impact on overall growth so far.
Elsewhere in Asia the gradual shift from an export led to a domestic demand driven economic model is continuing. As long as inflation remains low, this should mean decent growth in the region again. The main risks to Asian growth come from the US. If there is a more severe slowdown in the US economy, Asian exports will face difficulties and this will lead to production and employment cutbacks in many countries. Another economy in the region at risk from a global slowdown is Australia. Much of the growth there has been driven by the strength of commodity prices, boosting incomes and real estate prices in Western Australia. However, monetary policy is tight and a sustained drop in commodity markets could lead to a sharp correction in economic growth.
The global scenario we are working with is for continued growth with inflation and interest rates under control. Clearly there are risks to this benign outcome and apart from the macro economic uncertainties outlined above it would be remiss not to mention other possible risks. On the political side, market participants will need to keep an eye on North Korea and Iran’s nuclear ambitions, the possibilities of a regional crisis in the Middle East and more radical policies in places like Venezuela. The election of a Democratic controlled Congress in the US could also change foreign and trade policy and may allow some of the protectionist voices in the US to be heard more fully. China would be the target of any protectionist moves with the US likely to keep pressure on China to open up its own markets and allow its currency to strengthen. While impossible to predict, investors also have to consider the prospects of another oil shock or climatic events related to global warming (El Nino devastating crops in South America).
Despite all these potential negatives, we think it will pay to take a reasonably optimistic stance this year. One understated dynamic in the world economy in recent years has been the strength of global capital flows. The source of much of the increase in liquidity has been the Asian trade surpluses and the windfall revenue gains made by oil producers. The re-cycling of Asian surpluses by the regions central banks through the investing of their foreign exchange reserves has been important in keeping global interest rates low. That in turn has restrained any increase in the cost of capital even when economic growth has been quite strong. There is very little chance of these flows reversing in 2007 unless there is a wholesale change in exchange rate policies in Asia, which looks unlikely.
The oil revenues have also contributed to this flow of funds. They have also boosted economic growth in the main oil producing regions, noted by the strong performance of the Russian stock marker over the last year. While we do not expect another surge in oil prices this year, the level of crude is sufficient to sustain decent revenues into these economies. As such, many emerging markets will remain attractive destinations for investors in 2007.
In summary, a benign global economic environment, high levels of liquidity and low volatility suggest a similar pattern to investment returns in 2007 as over the previous year. This suggests a positive bias towards equities, with Europe looking attractive from a valuation point of view. Unless there are signs of corporate stress – which have been absent so far this cycle – then higher yielding fixed income assets should continue to deliver higher returns than government bonds. In the currency markets, we do not see a big weakening of the dollar against the euro or sterling. If there are to be significant moves in currencies they are likely to come either as a result of a change in Asian exchange rate policies (a further argument for exposure to Asian equities) or from a deterioration in the global cycle. Under such a scenario the yen would be the winner and cyclical currencies like the Australian dollar the losers.
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