With slightly more encouraging signs coming from the world's largest economies, sustainable growth is beginning to look more likely. However, with higher quality bonds likely to suffer, recovery still hangs in the balance
It has been refreshing to be reminded that share prices can rise as well as fall this year. However, after a virtually uninterrupted five month 25% rally there remain key questions to ask to support equities over the remainder of 2003.
At the same time as equities have seen a sustained rise, the bull market in government bonds has suffered a sharp setback, most notably in the US Treasury market. So is the bull market in bonds over? Will the positive trend for credit spreads and equities continue? Are deflationary and/or recessionary pressures easing? Let's look for some clues to the answers to these key questions.
As is usually the case, the US holds the key to most questions on the future direction of markets. Easing by the Federal Reserve, significant liquidity growth and loose fiscal policy should see growth recover in the US. However, with surplus capacity and the consumer still stretched, it is our view that growth will be low, perhaps averaging 2.5%.
Right now, consumption is rising and, although consumer confidence fell in June, it is still up 36% since March when the market bottomed. Retail sales in May were up and the housing sector is surprisingly strong. The key support factors here are the low level of rates and until recently the flattening of the yield curve.
However, constraints remain on consumption. Personal income growth is moderating, unemployment has risen to 6.4%, while consumer balance sheets are necessarily being rebuilt as shown by the rise in the savings ratio.
Furthermore, activity data is still not improving. Although industrial production in May improved, the year-on-year numbers are down and durable goods orders fell to their lowest level for six months in May. Capacity utilisation at 74.3% is down 1.4% year-on-year and clearly there is still significant excess capacity in the US economy. But surveys are consistent with moderate growth, which may start to eat into this capacity over time.
Investment spending has not yet turned, suggesting the positive impact of low credit spreads, low nominal interest rates and improved credit availability is still being offset by the available excess capacity.
So as for some time now the public sector continues to support the economy ' government spending is up 3.7% in real terms year on year in the first quarter and the government sector is the strongest growing part of the economy.
Looking at this finely balanced evidence, our central case remains that there will be economic growth during the second half of 2003 of 2.5%. However with low interest rates, strong money supply growth, low bond yields, the weaker dollar and strong government spending boosted by the tax cut, growth could accelerate in 2004.
What about inflation? Well, at present deflation risks persist but should ease during the third quarter. Core inflation is 1.6% but rose by 0.3% last month, and worries about importing deflation have eased with the dollar itself easing, but declining oil prices have resulted in the increase in the import price index falling to only 1.5%.
We expect core inflation to remain around 1.5%, given only a moderate improvement in demand and pricing power, and with unemployment at current levels cost pressures remain muted. Clearly the Fed wants to insure against deflation risk. However, assuming growth of 2.5% and core inflation of 1.5%, the probability of another Fed cut is minimal. If growth accelerates in 2004 to 3.5% and some pick up in inflation, the Fed may start to tighten.
An improved Euroland performance is likely given strong liquidity growth, government spending and lower interest rates. Growth in Euroland could recover to 1.5% for the second half of 2003. Although growth will probably remain feeble, deflationary and recessionary pressures are clearly easing. Certain important indicators are improving and consumer confidence may be forming a base. German retail sales are up and critically unemployment may have stabilised with unemployment at (an unacceptable) 10.7% for the second month. At the same time both core inflation and producer prices up by 1% or more.
Production data, however, shows no clear evidence of an upturn yet. Exports, given the strength of the euro, are set to remain low. Arguments for a recovery come from expanding monetary growth, the collapse of the IG Metall strike, the bringing forward of tax cuts and the apparent success in French pension reform. We expect inflation for Euroland to average 1.5% for the second half of 2003 and pick up in 2004 back towards 2%-2.5%.
In this environment, the European Central Bank may cut rates once more this autumn, with a tightening trend emerging in 2004. If this is the case, we would expect Bund yields to trade sideways before moving higher during the fourth quarter.
Japanese economic indicators show a feasible move out of recession/deflation. Activity numbers are slowly improving. Industrial production, although only up 1.5% year-on-year, has improved by 4.4% annualised in the three months to the end of May.
New orders are trending higher, the leading indicator improved in April and the Tankan Survey continues to improve. Consumption may be forming a base as real spending by workers' households by volume is flat over three months. Exports, however, remain under pressure.
Government spending is up 2% year-on-year and is the strongest component of economic growth, up 1.5% in the first quarter of 2003. Deflation is slowly ending, with inflation having increased every month since February.
Monetary conditions are slowly improving too. Slow economic recovery is now likely as reflected partly in the improvement in the Nikkei through 10,000. Annualised growth of 1% so far this year looks likely, with inflation moving to 0%-0.3%. Bank of Japan policy will probably combine zero interest rates, bank reconstruction and foreign exchange intervention to depress the Yen through 120. The recent Japan Government Bond (JGB) setback should continue with 10 year yields targeting 1.5% by the end of the third quarter of this year.
The extreme overbought condition in the US Treasury market in June when 10-year yields approach 3% has now reversed. Technical analysis suggests it is not over on a three month view, with 3.7%-3.9% possible. The volatility in the JGB market is unprecedented and yet Bunds are relatively stable. Overall, the extreme overbought conditions have now reversed but long term trend yield declines have been broken in the case of the US and Japan.
Our view is that economic growth of sorts may well emerge in 2004, with Japan experiencing the largest swing factor. Bonds at the quality end of the spectrum may come under more pressure in this environment but credit and equities should be supported once firm evidence of this recovery's strength and depth are seen. However, the balance is particularly fine at the moment.
Easing by the Federal Reserve, significant liquidity growth and loose fiscal policy, should see growth recover in the US but it will remain relatively low.
Indicators for consumer confidence and industrial activity do not look positive.
An improved Euroland performance is likely given strong liquidity growth, government spending and lower interest rates although growth will remain feeble.
Slow economic recovery is likely in Japan as many economic indicators have recently been improving in the country.
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