The scenario we have been predicting for more than a year, namely a clear dropoff in growth in the US, has taken shape. While Europe has held its stand at year-end 2006, we expect a slowdown also here. In contrast, emerging economies especially in Asia are producing positive surprises.
US weakening, but no risk of recession
With around 2% annualised quarterly growth in the fourth quarter of 2006, the signs of an economic slowdown in the US are quite obvious. The reason for the economic weakening is well-known: a correction on the real estate market (-38% yearly growth on residential investment in January 2007), which is now beginning to impact the overall economy. For example we have started to see a meltdown of the subprime mortgage market, which represents 10% of the overall mortgage market û with over 20 subprime lenders having either filed for bankruptcy or seen their stock prices plunge. While we do not predict a contagion to other part of the mortgage business, it shows that consumption will be affected one way or the other in the forthcoming months.
This is the basis for our US growth forecast of 2% for the next few quarters and for 2007 as a whole. We do not expect the US economy to pick up again until the fourth quarter of 2007, when the combined effect of interest rate cuts and a gradual turnaround in the construction cycle should take hold. GDP growth will probably remain below its long-term trend in 2008 as well, but this does not mean that we need fear a recession in the coming quarters. For that to happen, the US Federal Reserve would have to adopt a much more restrictive stance than the current one. We anticipate key rate cuts starting in June 2007, which will bring the federal funds rate down by a total of 1 percentage points to 4.25% at the end of 2007. This should cushion the flagging economy in good time and lend it renewed momentum in the medium term.
Europe: surprisingly doing better but for how long?
Economic growth in the European Monetary Union (EMU) accelerated to an above trend rate in 2006. Growth picked up in France, Germany, Spain, the Netherlands, and in Italy. By year-end European growth was at 3.6%, supported by strong investment activity and exports. The VAT increase in Germany (from 16% to 19%), which was considered as heavily impacting the European economies, has so far proven to be rather tame. It didnÆt protract consumption in the fourth quarter, the outstanding German growth being based upon the external sector and investment activity. It didnÆt produce a surge in inflation either, the actual effect on inflation being in January only one third of the projected one.
Nevertheless, on the back of tighter fiscal policies and the increase in European interest rates, we expect a slowdown in Europe from 2.7% in 2006 to 2.3% in 2007. The persistence of inflation remains a source of concern for the European economies. Consumer prices rose by 2.2% in the EU-13 in 2006. Due to higher energy prices and a rise in government-administered prices, especially in Germany, inflation should remain just around 2% during 2007. The European Central Bank (ECB) has continuously lifted its interest rates since December 2005. It will continue to do so in 2007 though at a slower pace. Our current forecast is for one hike in March and another one in the fourth quarter of 2008. The other major European economies are expected to be mildly affected (Sweden, the UK) or more severely (Switzerland) by the EU-13 slowdown.
Independent growth and delayed slowdown in Asia
A year ago, we were expecting Asian economies to moderately slow down in the wake of higher interest rates and lower exports. While the US economic growth in 2006 as a whole remained solid, which to certain degree has helped most Asian economies, domestic demand in major Asian economies, such as China, India, Hong Kong, and Singapore has played an increasingly important role in delivering such a remarkable performance. In 2005, the Chinese economy grew by 9.9% in real terms, it accelerated to a stunning 10.7% in 2006. Chinese authorities have introduced several measures to curb investment growth, such as interest rate hikes and higher reserve requirement ratios for banks or targeted property market restrictions to prevent a possible overheating of the economy. We expect these measures to show effect in Chinese growth data going forward. Furthermore, with the US economy slowing down, export growth should continue to lose steam. We think that Asia is not yet in a position to fully decouple from the US business cycle. Currently, however, we see domestic factors compensating for the US slowdown to a large extent: robust domestic demand in China and other Asian countries such as India, Indonesia or Hong Kong will compensate for the negative effects of lower export growth. Accordingly, we expect the Chinese economy to slow down only to 9.1% in 2007, which is lower than in 2006 but still strong.
With bank credit actually growing at a positive rate for the first time in almost fifteen years, Japan has finally overcome the deflation that followed the economic slump at the start of the 1990s. Capital spending has increased at an astonishing rate, as companies have expanded their plants and equipment in order to boost production. At the same time, private consumption is being buoyed by the recovery on the job market. The fourth quarter growth rate was at an exceptional 4.8% annualised, ie the largest growth rate of all developed economies. Nevertheless, we expect economic growth to slow from 2.2% in 2006 to 1.8% for 2007, mainly reflecting a more restrictive fiscal policy. While the rate hikes by the Bank of Japan were another concrete sign of the end of deflation, we expect price pressures to remain very low and therefore we foresee currently only one more rate hike in Japan, the earliest in August, ie after the Parliamentary elections.
For most Asian economies, we foresee a similar pattern to that for China, ie a growth slowdown from the current levels. Indonesia and the Philippines are exceptions, as we expect acceleration in economic growth in 2007. In 2006, Indonesia was suffering from the effects of an extreme fuel price hike in August 2005. This curb on growth is now gone and the Indonesian central bank is aggressively easing interest rates, which should stimulate domestic demand. In the Philippines, the central bank is on the verge of starting the easing cycle, while the high influx of money from abroad supports the domestic economy, and the fiscal situation has substantially improved. In other economies, namely Thailand, and probably South Korea, we are going to see looser monetary policies too. Although this should enable these economies to dampen the slowdown, they are not yet in a position to accelerate their growth from the current levels. For aggregate Asia ex-Japan, we forecast growth to decelerate from 7.6% to 6.9% in 2007. With a recovery of the US economy later in 2007, Asia should be able to post higher growth in 2008 again.
Asian currencies will continue their run
Although Asian currencies appreciated in 2006, most of them are still substantially undervalued and central banks have been keeping exchange rates artificially high by accumulating massive foreign exchange reserves. High current account surpluses and rising foreign exchange reserves are clear indications of this undervaluation. We believe Asian currencies will continue to appreciate versus the greenback and in mid-2007 after the expected euro strength runs out of steam, also against European currencies. The Chinese yuan and the Japanese yen will be closely watched by Asian central banks, which will be more willing to let their currencies appreciate, should both currencies strengthen. For the yuan, we expect an appreciation of around 5% per year going forward and for the Japanese yen we expect the highest appreciation potential in terms of valuation.
A turbulent year û risks remain in 2007
In 2006, Asia was hit by unexpected events such as North KoreaÆs nuclear test early in October. The military coup in Thailand, the corruption scandals and constant pressure on TaiwanÆs President Chen to resign and the Philippine state of emergency are some other major events highlighting the risks in 2006. While we expect less political turmoil in 2007, many of the surprises of 2006 will continue to be sources of uncertainty. Furthermore, with many parliamentary and presidential elections expected to take place in 2007, the political factor remains important for investors. Our central scenario might be affected by several other negative and positive factors. On the negative side, the geopolitical tensions in the Middle East might continue to put pressure on both sentiment and energy prices. A surge back to the $80 level in oil prices could seriously affect the global economy. As far as positive macroeconomic risks are concerned, in the US, the still buoyant labour market might compensate for the negative housing market effects. Asia, and especially China and Japan, might show even higher domestic demand than currently forecasted and thereby add some bounce to the world economy. However, solving, or at least mitigating, the US current account deficit problem, which will continue in 2008 will require both softer US consumption, which is growing at a slower pace than seen in the past 10 years, and sharply rising consumption by the rest of the world (especially Asia), thereby allowing US companies to export more. Currently, to merely maintain the US current account deficit at its current level, US exports need to grow 1.5 times faster than US imports.