GLOBAL ECONOMIS: A MID-CYCLE SLOWDOWN, NOT A RECESSION - JOACHIM FELS
We are witnessing the first financial crisis of the securitization age. It has now lasted long enough to meaningfully affect banks' and investors' ability and willingness to extend credit to the economy. As a consequence, Morgan Stanley's global economics team is cutting its global growth forecast. We expect global GDP growth will slow significantly, especially in 4Q07 and 1Q08, taking full-year 2008 GDP growth down by about half a percentage point, to 4.5% — and the risks to this number are on the downside.
However, we are forecasting a global midcycle slowdown, not a recession. We expect growth to reaccelerate in the second half of 2008 and more so in 2009. We bank on three factors to contain the collateral damage from the US housing slump and consumption slowdown: (1) robust consumer spending in Europe; (2) strong capital spending by corporates and governments worldwide, especially in the emerging markets; and (3) global monetary easing led by the Fed, which we expect to lower short rates by 100 bp over the next six months. Other major central banks could follow, the Bank of England likely before year-end, and the ECB possibly early next year. Note also that with many emerging countries on a dollar standard, Fed cuts imply an easier monetary policy stance in these countries as well.
Market implications: (1) In my view, easier global monetary policies over the next year imply higher inflation in future years. Central banks are refocusing on stabilizing financial markets and containing the economic fallout, at the risk of creating higher inflation in the later stages of this cycle. Global yield curves are likely to steepen further as a consequence. (2) Some argue that there is no asset market left to inflate, and monetary easing therefore won't help. This may be true for housing and credit markets. But there is one important asset class where valuations look reasonable and which would benefit from a midcycle slowdown and monetary easing — equities.
GEM EQUITY STRATEGY: CLIENT CAUTIOUSLY OPTIMISTIC AS WE ENTER A SEASONALLY FAVOURABLE PERIOD FOR EM RETURNS - JONATHAN GARNER
This week we provide feedback from our meetings with long-only and hedge fund clients in the US and Asia. There was considerably more agreement amongst long-only GEM managers in the US with our thesis of EM medium-term growth leadership than was the case amongst global PMs. About one-third of the GEM managers we met with were on the same page as us on the heightened likelihood of a very strong market (or even a bubble) developing within EM assets over the next two years. We saw all but unanimous agreement that China’s growth and financial markets are key to the asset class over the next two years (much more so than the US).
Global hedge-fund managers as well as some long-only global PMs were more bearish generally, in particular on the topic of the risks to the global financial system going forward. The most optimistic PMs we met were based in Hong Kong running Asian mandates.
Looking at specific countries, there was plenty of optimism on Brazil, although the pace of credit extension growth worried a few. Taiwan was perceived as having the deepest value characteristics in the asset class. Business cycle downside risks expected by most to be highest in Mexico (due to sensitivity to US), South Africa and India. Sentiment on Russian political and corporate governance risk was still very negative.
Last, we are entering a seasonally favourable period for EM equities, with 4Q returns traditionally the highest of any period. However, we expect more volatility than in previous years and will monitor various events that we think could affect market sentiment in the weeks to come.
CURRENCIES: TRACKING THE CURRENCY SEASONS - STEPHEN L. JEN
Obviously, a soft landing in the US will have consequences for the rest of the world. But the economic impact will likely not be overly severe. We look for a soft landing in the US and soft de-coupling in the rest of the world. I have looked at what I think the actual FX relationships will be this time around, using a model of the “seasons” of the economic and financial life cycle that I used after the 2001 recession (see the Sept. 6 FX Pulse for details on this model).
There are several special factors we need to consider.
(1) Valuation is a problem, as the USD is already quite cheap relative to many other currencies. (2) There is also the risk of repatriation, not just for Japanese investors, given how much they have invested in non-JPY assets since last summer, but also USD-based investors. If things really get ugly, I can see the USD getting a safe-haven bid. (3) Given the strength of the economies outside the US, a soft landing in the US could still permit other central banks to tighten interest rates. (4) Equities are not that richly priced. It will be hard for global equities to sell off, in my view, even if the US slows.
Putting currencies into seasonal quadrants: We created a chart with global growth on the x axis and equity markets on the y axis. The upper right quadrant is when growth is strong and markets buoyant, which we call summer, while the lower left is winter, when everything has turned down. Typical “summer” currencies are those in Asia and other emerging markets, plus Australia, while the Swiss franc is a typical winter currency. I would characterise EUR and GBP as “fall” currencies. I also now view the JPY as a “winter” currency, given how much capital outflows have taken place since summer 2006. For the time being, I believe we are transitioning from summer to fall. Unless the US slips into recession (winter), I would not expect the summer currencies to do all that badly, while the EUR and GBP should benefit.
I am turning a bit more cautious — an incremental change in my view, not a U-turn. I still think that the global economy is healthy and that this US slowdown, while more evident and a bit more severe than I had thought, will be a cyclical slowdown, manageable by the Fed.
Inflation is a multiyear risk. The sharper deterioration than I expected in the US economy's outlook will obviously affect the financial markets. But I still think the global economy looks great and should withstand a mid-cycle slowdown in the US. Potential aggressive rate cuts by the Fed and other central banks, if necessary, will sow the seeds for a robust economic recovery in 2009, and a potentially powerful rally in global equities after this 6-9-month soft patch. I still view the real risk, from a multiyear perspective, as inflation.
US ECONOMIS: DOWNSIDE GROWTH RISKS BECOME REALITY - RICHARD BERNER
The downside risks to US growth have morphed into reality, courtesy of the shock from abruptly tighter financial conditions. Paced by a deeper and longer housing recession, real GDP in the US will expand at just a 2% pace over the next six quarters, we now expect, or 0.6% below the forecast we published a month ago. The evidence of tighter credit conditions is fairly widespread — affecting both bank lending and securitization — the two main avenues of financial intermediation. Bank funding costs have spiked, and the commercial-paper market has started to shrink. Problems in important segments of the mortgage
market are likely to lead to a prolonged decline in residential construction activity.
Statistical quirks in employment number. Last Friday’s employment report was much weaker than anticipated, but several statistical quirks may help explain some of the softness. A relatively late August survey period appeared to help trigger a very sharp drop in the labor force participation rate for teenagers. If students left their summer jobs before the August survey there could obviously be a significant negative impact on the payroll employment tally as well.
Spillovers from tighter lending standards and higher borrowing costs also likely will hobble consumer and business capital spending. For the consumer, a deeper decline in home prices is expected to trigger a negative wealth effect that will shave about one-half point from consumption over the next year or so. In contrast, still-solid global growth seems likely to help thwart a recession. The increased slack in the domestic economy could hasten a moderation in core inflation to below 2%.
The Fed will have ample latitude to respond to softening growth, likely easing monetary policy twice this year and twice early in 2008. However, the market is already fully priced for such an outcome. Thus, we expect little movement in longer-term Treasury yields.
Our first look at 2009 suggests a more cyclical profile, with growth rebounding from well below trend to slightly above
it as the housing market stabilizes and easier financial conditions provide stimulus. The Fed is expected to respond
by recalibrating monetary policy with the funds rate moving back up to 5% or so.
ASIA/PACIFIC EQUITY STRATEGY: BEWARE SELECT EARNINGS RISK - MALCOLM WOOD
Our G7-developed economy leading indicators appear to be rolling over. In addition, the fallout from the US-led credit squeeze is tracking worse than we expected. The sharp contraction in the commercial-paper market may also lead to some inventory liquidation. In our view, this adds up to earnings risk in sectors and markets particularly exposed to the G7 economies, such as the technology, materials and industrials sectors, and Taiwan and Korea. We are underweight these sectors and markets.
A peak in G7-developed economy indicators. Our G6 leading indicator has moved materially lower since peaking in June. The slowdown appears broad-based, as reflected in our Momentum Index falling sharply in July.
Fallout from the US credit squeeze is tracking worse than expected. Housing and employment indicators have been worse than expected. The gasoline price tailwind appears to be over. The sharp contraction in the commercial-paper market may lead to some inventory liquidation.
Asia-Pacific is not exempt from earnings risk. We see earnings risk in the technology, materials and parts of the industrials sector, whilst Taiwan and Korea also appear exposed to weaker G7 growth.
CHINA EQUITY STRATEGY: CHINA'S RESISTANCE TO DE-RISKING - IT DEPENDS - JERRY LOU
We remain constructive on Hong Kong listed China equities, despite worrying employment data in the US and rising concerns of a US-centric recession and global derisking in financial markets. The Hong Kong listed China equities have a unique liquidity booster thanks to China’s coming deregulation of retail capital to invest in Hong Kong. However, if the US economy confirms a recession, in which case panic de-risking in EMs would likely materialize, our view
would turn more bearish because de-leveraging investors in panic would likely take profits from Hong Kong listed China equities to plug holes in their home balance sheets. While another rally in global financial markets seems quite unlikely, with the US slowdown clouds gathering again, we still believe offshore-listed China equities in Hong Kong should outperform in a moderate EM de-risking scenario.
Risks to our Call: China’s investors should realize their risks are US-centric. If the US reports more negative economic data to confirm its slippage into recession, a panic de-risking in global financial markets seems unavoidable. If that picture materializes, offshore-listed China equities in Hong Kong, thanks to strong performance recently, would underperform as a major target of profit-taking to fund leveraged investors’ liquidity.
