Calyon's 2006 forecast: Buckle up!

Expect a weakening US dollar, strengthening renminbi and steady oil prices.

'Tis the season to make forecasts - and hope no one remembers come December.

Calyon Corporate and Investment Bank's 2006 view of the road ahead is not full of doom and gloom for Asian economies, currencies or bonds in 2006. But the firm expects, "bumps on the road...enough to fasten seat belts."

At the base of the bank's premise is that the US dollar will weaken over the next year. However, oil prices will remain high but relatively steady -- thanks to continued strong global gross domestic product growth, which drives oil product consumption.

The big currency story will be that China may react to a weakening US dollar by letting the renminbi climb more strongly than in 2005. That is not shocking news in and of itself, but Calyon's forecast that the mainland may let its currency appreciate by as much as 7.6% is a bit of an out-on-the-limb prediction.

On the bond side, Calyon expects Asian spreads to widen, particularly for high-yield, in response to a rise in US yields and the current rich valuations. As a result, bond returns will be meagre and investors need to be cautious in bond picking and react to the news.

However, Calyon bankers argue that fears over a possible deceleration in Asia this year are overdone. Indeed, the bank calls for Asian GDP growth to decelerate only slightly, from 7.8% last year to 7.4% in 2006 (and 6.6% in 2007).

The bank forecasts 9.% growth for China (down from an estimate of 9.8% for 2005) on the grounds that some of the tightening moves of the past year will have finally kicked in. But the real drag on the region will come from Indonesia, with a forecast of only 3.9% growth in 2006 as opposed to an estimated 5.4% growth last year.

The bank argues that private consumption has already displayed signs of weakness, and this should continue in the coming months against a backdrop of higher fuel prices. With investments dwindling due to higher interest rates and the central bank likely lowering interest rates at a gradual pace so as not to put the monetary stabilisation at risk, there is a risk that the contribution of investment to Indonesia's GDP will weaken this year.

On the positive side, Korea and Taiwan are two countries Calyon forecasts will have more robust GDP growth in 2006, with Korea looking at 4.8% GDP growth in 2006 from an estimate of 3.8% growth last year and Taiwan gunning for 4.5% growth this year up from 4.0% in 2005. Korea will benefit from both its stronger export-driven economy and renewed private consumption as it shrugs of the past two years of sluggishness inherited from earlier years of excess household indebtedness. Taiwan's economy should tick along on the strength of low unemployment and low real interest rates.

Much of the predictions stem from a view of the US dollar weakening, thanks to US growth slowing, core inflation remaining above desired levels and consumer spending slowing, reflecting the impact of high energy prices and less mortgage equity extraction. As a result, Calyon expects the Fed will respond to core inflation creeping higher by continuing its rate hikes to about 5% later this year. Of course the ominous dark cloud over the US story is the one marring the sweet little picture of the housing market. While the bank is hopeful that the current slowdown in property sales is a soft landing, the possibility of a bubble bursting lingers.

On the oil front, Calyon says the 2006 price forecast for WTI NYMEX front-month is $58.13 compared to $56.66 last year - so it is not expecting a significant increase in price. Thanks to the strong GDP growth predictions, there should be healthy oil demand, which will keep spare crude refining capacity and spare crude production at low levels, which will thus underpin the oil markets. Of course, there is a caveat. A recession or economic slowdown presents the main downside risk to the forecast, because oil-demand growth would weaken and the capacity constraints would ease. In addition, the non-fundamental support from active financial investors, such as hedge funds, could evaporate or turn negative.

On the currency front, Calyon argues that stabilised oil prices should enable central banks to limit monetary tightening. The bank forecasts Asian short-term interest rates rising by only 21bp on average in the first half of 2006, compared to an increase of 75bp for the Fed funds target rate. Calyon thus reckons that beyond the recent appreciation against the US dollar, Asian currencies could consolidate in the short term, only to appreciate afterwards, particularly if the US dollar resumes across-the-board depreciation.

The Taiwan dollar, Singapore dollar and the renminbi have the most potential for appreciation against the US dollar, according to Calyon. While China will likely keep the greenback as the main reference for the renminbi, Calyon expects apreciation to accelerate as the US dollar slides. So the bank forecasts 7.5 for the USD/RMB exchange rate by the end of this year (or a 7.6% appreciation in 2006).

Meanwhile, Asian credit spreads have reached their bottom according to Calyon, and so the bank expects them to rise by 10bp-20bp for high-grade and 25bp-35bp for high-yield. Driven by the abundant liquidity and search for high yield, both high-grade and high-yield spreads have reached their fair values on average, leaving no room for further tightening, argues Dilip Parameswaran, executive director, credit research, capital markets for Calyon. Parameswaran expects US yields to start rising (with the 10-year US Treasurys yield to shoot up to 5.1% by the third quarter), and for Asian spreads to follow.

On the sovereign front, those bonds are likely to be supported by the positive economic picture, but their spreads will probably widen along with overall Asian spreads. Calyon expects the Philippnes and the Indonesian spreads to be the main wideners. Hong Kong bonds are likely to be supported by a positive property outlook, although weaker private demand and tourism could be challenges.

Bookmark this page, and see if these forecasts come true in 11 months time!

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