North America

  • Consumer confidence, as measured by reported indices, continues to sag and there are indications that retail sales aren’t registering the expected gains. The exception has been auto sales, helped by generous financing terms. Looking forward, there are expectations that another round of mortgage refinancing will lead consumers to return to the malls in large numbers but such hopes may be exaggerated.
  • Lower mortgage rates are good for the consumer and higher oil prices are definitely not. Crude oil prices have come off their highs but remain elevated, and have generally been above the upper bounds of OPEC target rates. This reflects a risk premium since around May of this year, and much of the price rises have already been incorporated in the consumer inflation rate. The main danger is of a further sustained rise, in the event of war. It would represent a hit on household disposable income and could dampen spending. Higher military spending would only partially offset lower consumer expenditures.
  • It does not look like the Bush administration will back off from a conflict with Iraq, despite considerable international opposition. Of course, some of the voiced opposition, even in the Arab world, is not genuine and is intended for public relations purposes. Regime change in Iraq may be desirable, but the main difficulty is how to effect it without making a mess. Unlike Afghanistan, Iraq is a very strategic piece of terrain where regional powers have stakes to protect. A quick "victory" in Iraq will be positive for the markets in the short term. A messier outcome will pose greater risks for a still fragile global economy. Meanwhile, the United States is still engaged in military operations in Afghanistan, finding it difficult to tie up loose ends.
  • The rally off the July 24 lows, which lasted for five weeks, ran into resistance last week. For all the excitement, the Dow actually ended up slightly in the red in August, losing 0.8%. Moreover, September is generally a dodgy month for the equity market and there aren’t too many positive factors on the horizon to restart a strong upward momentum.
  • There appears to be a greater comfort factor among investors regarding corporate management behaviour. But two main issues need to be addressed in this regard. First, to the extent that managers present "truthful" financial statements, the earnings picture will be less rosy than would have otherwise been the case. Second, they may be less prone to engage in risk-taking activities and innovations that may possibly land them in legal trouble. In consequence, productivity growth is likely to be affected in a downward direction. Cost-cutting measures will constitute a primary means of boosting profits, but after all the trimming that was carried out in the last decade there isn’t an awful lot of slack that can be eliminated.

Europe

  • Weak second-quarter growth in the Euro-zone is unlikely to be significantly reversed in the third quarter, which means that growth will continue to be below the trend rate. The OECD lead indicator is now pointing to a deceleration in activity. By and large, recent releases of economic statistics have disappointed analysts on the downside.
  • Inflation has, in the past, been reluctant to move below the European Central Bank’s 2.0% target rate because of a number of negative forces, including a weak currency, rising food prices and the introduction of the euro for common use earlier this year. Going forward, there are several positive factors that should put downward pressure on the inflation rate. Even if the ECB may be hesitant in cutting its target rates in the near term, there is still a downward bias in Euro-zone interest rates.
  • Weak output growth, a sluggish global economy and an inflexible labour market are showing up in poor productivity performance and consequently in disappointing earnings growth numbers. Stock markets have adjusted accordingly as consensus estimates have been revised down.

Asia/Pacific

  • Given the weak state of domestic demand, output growth in Japan has relied principally on exports to Asia. Currently, private-sector capital spending and consumption do not show any signs of sustained recovery. With U.S. growth also flagging, Japan’s export-driven strategy is becoming increasingly risky.
  • Japan's trade and current account surpluses have continued to rise rapidly, due to falling imports and rising exports. Asian demand for Japanese goods was an important factor on the export side. Meanwhile, the yen's strength has not been a limiting factor, thus far. Of course, Japan is a very large creditor country and, via its surpluses, is accumulating additional foreign assets.
  • The recent decline on many Asian bourses is partly related to investor concerns about the fragile global recovery and its impact on local economies. However, the outlook for non-Japan Asia is reasonably positive, as long as the United States avoids a recession.

Bonds

  • An attack on Iraq, provided it does not spread to the rest of the Arab world and the oil price spike is temporary, is unlikely to lead to a sustainable rise in yields at the longer end of the U.S. Treasury curve. If a longer-lasting conflict shapes up, it will put downward price pressure on longer maturities because of higher defence spending and wider government deficits. Also, a sustained increase in oil prices may raise expectations of amplified inflationary pressures. Hence, there will be safe-haven demand for shorter maturities leading to a steepening of the yield curve.
  • Fed policy is tied to economic and financial market prospects and, with inflation still contained, a war in the Middle East is unlikely to elicit action from policymakers. If anything, it makes a cut more likely. However, once the conflict is underway market expectations of further rate cuts may diminish.

Currencies

  • A short, sharp and successful war in Iraq will be dollar-positive in the short term. However, a longer drawn-out conflict will favour those currencies with creditor status such as the Swiss franc, the yen and even the euro. In an uncertain environment governed by crisis, creditors tend to repatriate funds and refrain from extending credit to debtors.

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