Analysts warn that a significant slowdown is unavoidable, given the continued spreading of the housing market's troubles.
By AARON LEITNERbrazil money matters 88 (photo credit: Bloomberg)"The entire world economy rests on the consumer; if he ever stops spending money he does't have on things he doesn't need - we're done for." - Bill Bonner
In the US, November's economic data provided mixed signals regarding the debate over whether the US economy is headed for a full blown recession or a soft landing. The Q3 GDP report was revised from 3.9% to a 4.9% annual growth rate; for the most part due to upward revisions in inventories and exports. However, most of the data released was poor, showing softer consumer spending, tumbling consumer confidence, falling durable goods orders, declining corporate profits and an ongoing collapse in the housing sector. Home prices in the third quarter slid the most in two decades; October's construction spending plummeted and existing-home sales declined - the 15 companies that constitute the S&P's Homebuilding Index have lost about $35 billion of market value and the index has tumbled 62% this year. Consumer confidence dropped to the lowest since Hurricane Katrina, third-quarter corporate profits fell versus the previous quarter and the growing supply of unsold homes threatens to push real estate values even lower.
With the impact of the energy prices expected to take full effect during the cold months of Q4 and their property falling in value, American consumers are expected to curb spending. Current quarter consumption trends raise concerns of zero growth in this sector, which represents 70% of GDP. Also, the housing sector recession, which took about 1% off GDP growth in Q3, should continue to erode growth well into 2008.
Several large financial services companies reported loss writedowns due to erosion of the value of mortgage-based financial products. As a result of the subprime crisis, lending standards have been tightened and credit has become scarcer. The tightening of financial conditions has weakened the demand for assets, further aggravating problems in financial markets and adversely affecting consumer demand. Consumer credit has been a major support factor for consumption in recent years. A household credit crunch is shifting consumption outlook to an even more downbeat scenario.
Analysts warn that a significant slowdown, if not recession, is unavoidable, given the continued spreading of the housing market's troubles into other sectors and the worsening of important economic indicators. In a supplement to minutes of its October meeting, the Federal Reserve lowered its forecast for US economic growth in 2008 to 1.8%-2.5% from the 2.5%-2.75% projection that was made in June. Prospects for next year do not look as favorable because the problems in housing continue to drag on. The Fed commented that uncertainty about the growth outlook is greater than that for inflation.
However, there are signs that the US economy may be able to weather the crisis. November's regional surveys of the business climate turned out to be better-than-expected. Consumer spending and incomes are still growing, albeit much slower then before. The labor market still shows resilience and the increase in exports partly helps to balance the negative effect of weak consumption on economic growth. Another piece of good news are steps being taken by the government that may help slow financial companies' credit losses and halt the rise in foreclosures.
Eurozone
US troubles with the burst of the housing bubble and an overly leveraged consumer do not apply to the Eurozone economy. Nevertheless, a recession in the US is going to have an adverse affect on growth and negatively impact the financial sector as a result of European banks' exposure to US asset-backed securities. The Eurozone economy is also feeling the unfavorable effects of the strong euro. Risk to price stability persists in the form of continued inflation in the energy and food sectors. The preliminary CPI report for the Eurozone showed a spike to 3% y/o/y in November, the highest since 2001. During the third quarter, Eurozone growth rebounded from 0.3% q/q in Q2 to 0.7% in Q3, or an annualized 2.6%. The leading indicators suggested a mixed outlook; economic sentiment and consumer confidence indexes were down, while the manufacturing PMI and Industrial Sentiment indexes were higher-then-expected. However, downside risk to growth is increasing. A slowing US and UK economy, credit crunch, soaring Euro and weakening consumer confidence are likely to distress economic growth going forward.
UK
Concerns about downside risk to growth took higher priority over the fears about upside inflation risk. Growth is slowing in response to the credit squeeze and renewed weakness in the housing sector. Q3 GDP data was at 3.2% y/y, which painted a positive picture, but in Q4 and 2008 the ongoing credit crunch will undoubtedly impact the UK economy.
The string of noticeably softer data and survey evidence relating to the services sector, consumer confidence and the housing market has clearly raised fears that there is an increased risk that growth could slow more sharply - below 2% y/y - over the coming months. Home prices dropped 0.8% m/m, the biggest monthly decline in 12 years, October's mortgage approvals fell to the lowest since 2005. Consumer Confidence index fell to the lowest since March 2003, and Q3 economic growth unexpectedly slowed to 0.7%, the weakest in a year. This data suggests that the economy has entered into a period of below-trend growth.
Japan
Following the decline in GDP growth in Q2, the Japanese economy rebounded in Q3 and registered 0.6% q/q growth. Exports rose by 2.9% q/q and private consumption by 0.3%. The export sector is less dependent on the US as strong demand from emerging markets is spurring export growth. However, at a time when global economic growth may be slowing down, over-dependence on exports might be risky. Data on consumer confidence (at a three-year low in October) points to a slowdown in private consumption growth. Wages are not expected to rise as the labor market seems to have finished the tightening cycle. October's unemployment rate held steady at 4% after rising for two consecutive months. Core CPI climbed 0.1% in October from a year earlier, signaling Japan's first signs of inflation this year. Inflation is expected to remain low as long as there is no substantial increase in wages. The Bank of Japan expects GDP growth of 1.8% this year and 2.1% next, while the CPI is projected to stay unchanged this year (0%) and register a 0.5% increase in 2008.
Emerging markets
China has been growing rapidly for more than 20 years and continues to expand at a breakneck speed, making it the single most important contributor to world growth. China's economy is expected to grow by 11.5% this year and by 10% in 2008. Moreover, these growth rates are expected to be sustained in a more difficult global environment.
The Indian economy grew by a robust 8.9% y/y in fiscal Q2 08. Investors continue to be attracted to the second-fastest growing major economy. The popularity of Indian assets has been a cause for the rupee's appreciation. Surging liquidity has brought a rise in inflation pressures - so far, inflation has been stable, although domestic oil prices haven't been adjusted for the last 18 months. India's economy is expected to grow by 8.9% in the fiscal year ending March 2008; the expected inflation rate is 5.4%.
Russia's economy continues to expand rapidly. In Q3, the GDP expanded at an annual rate of 7.6% after growing by 7.8% in Q2. So far, the effect of the global credit crunch on Russia is less significant than analysts feared. Capital investment and consumer spending are strong and remain the main drivers of growth. 2007 will be Russia's ninth consecutive year of economic growth. There are, however, issues of concern. Russia's immediate trouble is the high rate of inflation that has been fueled by the inflow of capital, rising real incomes and the central bank's limited ability to influence prices. 2007's inflation rate is expected to hit 11.5%-12%.
In Latin America, Mexico is more dependent on US economic developments than many other emerging economies since the US buys about 80% of its exports. A healthy domestic economy, high oil revenues and a surge of infrastructure investment, provide some cushion. However, the International Monetary Fund warned that US economic woes may reduce Mexico's GDP growth rate from 3.75% to 3% next year.
Brazil's economy is growing at the fastest pace since 2004, as rising employment and lending, coupled with the benefits of a global commodities boom, fuel domestic demand. The economy is likely to grow just over 4.5% this year.
Equities markets
Equity markets experienced significant losses in November as the US led global markets in a downward spiral. US markets maintained a negative tenor through most of the month as a result of a series of negative reports. Citigroup announced that its mortgage-related losses could approach $11b. Merrill Lynch also reported that it absorbed $7.9b. in losses related to the subprime crisis. The Fed issued supplementary meeting minutes indicating continuing concern over the economy's fragility, while Goldman Sachs came out with a report predicting the likelihood of a $2 trillion cut in available borrowing funds and a significant risk of a US economic recession.
In Eurozone, markets were down on worries over a weakening US economy and a ripple effect on European economies. In addition, a strong Euro amplified concerns over a decrease in exports, while rising oil prices also contributed to a concern of an adverse impact on economic growth. This was backed up by a ECB downward revision forecast for 2008 GDP growth.
The UK trade deficit continued to grow and Q3 economic growth surprised analysts with the lowest reported number in more than a year. It appears that Eurozone and the UK are at an early stage of an economic slowdown; accompanied by a series of interest rate cuts by both central banks.
The US is at the advanced stages of a soft landing. It has been in "recession lite" for over six months now. US economic prospects will start to turn around in the first half of 2008 even as Europe and the UK continue to experience an economic slowdown. European/UK equities are less attractive than US equities; especially large international companies. Japanese equity markets declined steeply due to concerns over the impact of a weaker U.S. economy and reduced consumer demand. In addition, the housing market showed signs of increased weakening and Japan's five largest banks lost 27% market value due to the credit crisis. Also, Japan's leading indicators continue to be flat, suggesting unimpressive economic growth. Japan remains an enigma and expectations for attractive returns, in 2008, from its equity markets are in doubt.
Though emerging markets suffered a rough ride, positive economic fundamentals remain intact. Asian and Latin American countries continue to exhibit overall strong economic fundamentals. These economies are on terra firma and are poised to reward equity investors again in 2008. Actions by India's central bank appear to have had a calming effect on inflationary pressures. Both India and China are expected to demonstrate strong economic growth in 2008. China's domestic-traded equities are at very high valuations and it would not be a surprise to experience a significant correction in 2008. This correction should be short-lived and is not expected to significantly impact China's continuing strong economic growth.
Fixed Income
A flight to safety was again the theme for November as investors reversed direction and exited from higher risk asset classes. This coupled with expectations of further Fed rate cuts and the threat of an ECB rate hike provided US treasuries with attractive returns
Currencies
The US dollar gained against most major currencies. A flight to safety caused a run to US treasuries, a Bank of Canada rate cut and expectations of a BoE rate cut caused a strengthening of the greenback. The Yen strengthened against the dollar as investors closed carry-trade short positions.
Alternative investments
Gold continued to gain and can be expected to retrench in view of a strengthening dollar in the first half of 2008, coupled with declining oil prices resulting from a milder than expected US winter and reduced oil demand from a softening US economy.
Hedge funds displayed lackluster returns for November, primarily due to short-term market turbulence. Returns in the macro and quant-driven strategies were more mixed while returns in arbitrage-related strategies were positive. Losses in currencies and US fixed-income were responsible for the negative performers in the macro strategy.
aleitner@tandem-capital.com
The author is global investment strategist at Tandem Capital.
Yulia Vaiman, a macro research analyst at Tandem Capital, contributed to this report.
