Comment: Pending economic slowdown offers no respite: Haydn Davies, Chief Economist, Barclays Global Investors

Inflation vigil is spurring policymakers into action, despite signs that activity is weakening moderately worldwide, notes Haydn Davies in his August review.

Bank of Japan ends era of free money
 
The Bank of Japan finally signaled the end of the era of zero interest rates in July by raising rates to 0.25%. Japan's long slump has meant that the only other time the Bank has raised interest rates in the past 16 years was in August 2000, only to shamefacedly cut them again six months later as the apparent upturn in activity quickly fizzled out.

The case for higher interest rates is that after more than 10 years of hesitant growth, Japan's economy has finally recovered from the aftermath of the late 1980s asset-price and investment boom. Japan is, for example, one of the few countries in the world where house prices look cheap relative to rents and prices across the economy have finally stopped falling. But with activity now
looking a little softer, the Bank of Japan's timing looks far from auspicious. Export orders have begun to slow and consumer spending - the upturn in which has helped the current recovery to stand out from the failed recoveries that have come before - has also been cooling in recent months, despite the moderately upbeat jobs market.

Nevertheless, at the same time as it raised interest rates, the Bank sought to soothe investors' nerves, confirming its intention to keep rates low for some time and to tighten policy only very gradually. The Bank's reassurance helped bond yields to ease and the weaker economic outlook, together with the fact that 10-year bond yields already offer a large premium over the likely path of money-market rates, should ensure that Japanese bonds outperform other government bond markets for the time being.

However, the prospect of Japanese money market yields continuing to offer investors a large discount to opportunities elsewhere undermined support for the yen and the currency has wilted, reversing its recent rally. The interest rate outlook is likely to remain a drag on the currency for some time to come. Sentiment towards Japanese equities has also suffered in recent weeks, with foreign investors becoming net sellers of the market.

One ingredient in Japan's upturn in the past couple of years has been the strength of demand from China. But with the Chinese authorities taking further steps to rein in bank lending in recent weeks, orders from China are likely to soften. With consumer spending also ebbing, the economic climate is looking more questionable and Japanese equities will continue to under-perform other equity markets.

US slowdown may not be sufficient to satisfy the Federal Reserve

All eyes have been on the Federal Reserve in recent weeks to see if either the statement that accompanied its latest interest rate hike or the semi-annual testimony of its chairman, Ben Bernanke, to Congress would provide any further clues to the likely path of interest rates.

The one lesson that has emerged is that policymakers are almost as unsure as the markets and are watching the economic indicators closely. The Federal Reserve's dilemma is that underlying inflation has climbed to its highest level in four years and is continuing to edge higher, while the economy is already beginning to cool.

But if the slowdown already underway is not sufficient to temper inflation, then the danger is that workers come to expect higher inflation to persist and ask for higher wages to compensate, causing inflation to begin spiralling out of control. So far there is no sign that wage inflation is beginning to accelerate over and above the rate of productivity growth - despite the unemployment rate having fallen to 4.6%. But policymakers know that it would be much more difficult to stamp out inflation if it starts to become ingrained.

So far the slowdown has been mostly confined to the housing market. Home sales have fallen 8% over the past year, the worst slide for more than a decade and the overhang of unsold properties has jumped. Consumer spending has remained fairly resilient and corporate investment is still very upbeat, buoyed by the surge in profits in recent years. However, profit warnings from semiconductor chip makers Intel and AMD, as well as PC manufacturer Dell might be the first signs that the slowdown is spreading beyond the housing market.

The technology sector is usually one of the first to feel a change in the climate. Nevertheless, the financial results and outlooks of other firms in the technology sector, such as Google and Microsoft, have comfortably surpassed expectations. For the moment, therefore, the economic climate looks fairly negative for both Wall Street and the bond market. On the one hand, the housing market is experiencing a sharp slowdown, which is likely to exert a sizable drag on consumer spending in the coming months as the huge boost from mortgage equity withdrawal fades.

On the other hand, the evidence of a slowdown does not yet look sufficient to satisfy the Federal Reserve. As a result, bond yields may still have further to rise, with the US market still looking expensive relative to markets elsewhere. The downbeat economic climate will also mean that US equities lag other equity markets across the globe, particularly since the US market still looks fairly expensive in comparison. The interest rate outlook is still helping to support the US dollar, though, despite the drag from high commodity prices and the economic slowdown, and the currency shows no sign of flagging just yet.

Upturn spurs the European Central Bank into action

So as not to disturb policymakers' holiday plans, the European Central Bank (ECB) had scheduled only a brief conference call for its interest rate deliberations at the beginning of August. However, Governor Trichet has now summoned a full board meeting back in Frankfurt, meaning that ECB policymakers will have to put their holiday plans on hold, and in effect signalling that the ECB will raise interest rates by another 0.25% to 3.00%.

Like many investors, policymakers had been concerned that activity had failed to match the surge in business confidence and that the recovery was partly a mirage. However, now that activity has begun to catch up, the ECB's earlier misgivings have given way to caution about the outlook for inflation. Although underlying inflation across the region - excluding energy and food prices - is just 1.4%, and only 0.7% in Germany, the ECB is concerned that higher energy prices will eventually push up wages and prices across the economy.

The sharp climb in consumers' expectations of inflation over the next 12 months, as measured by the European Commission's monthly survey, appears to give some justification to policymakers' fears.

With headline inflation currently 2.5%, uncomfortably above the ECB's 2.0% target, policymakers are worried that expectations of higher inflation could become ingrained. Moreover, it is not just inflation that is outpacing the ECB's target. Strong growth in bank lending means that the money supply is growing at a rate of 9% a year, twice the ECB's 4.5% ceiling, and its fastest rate since monetary union.

Nevertheless, policymakers need to be mindful of the likely headwinds to economic growth from planned tax rises next year in Germany and Italy. Moreover, there are signs that the recovery may begin to lose momentum towards the end of the year and consumer spending remains disappointingly sluggish. The fixed income markets no longer look so complacent about the likely path of interest rates; the money markets are discounting interest rates reaching 3.5% before the end of the year and 10-year government bond yields now look good value compared to markets elsewhere.

Moreover, the likelihood that activity will begin to cool towards the end of the year may well stay further rate hikes for a while, despite the fact that policy would still be fairly loose by historic standards. In the meantime, the ECB's more hawkish stance bolsters the outlook for the euro a little. However, the currency's overvaluation and the drag from high commodity prices, which push up the region's import bill, mean that the currency is unlikely to make much headway.

Although the recovery may be starting to run out of steam, the upswing still looks fairly strong and should continue to boost the region's stock markets. The recent boom in profits also means that European equities look good value, helping to make up for fairly lacklustre sentiment and insulating markets from any global slowdown. For the moment, therefore, the prospect of a global slowdown should not be sufficient to deter the region's investors and European markets should have further to climb.

UK equities attractive in a nervous market

The revelation that over the past five years the UK economy grew between 0.1% and 0.2% a year more quickly than statisticians originally estimated ought to be good news. It means that the UK grew as quickly as the US over this period despite weaker workforce growth. However, the news gives the Bank of England something to think about and potentially gives the Chancellor of the Exchequer a headache. Under the Chancellor's so-called 'Golden Rule' the government must balance the current budget - ignoring investment spending - over the full economic cycle of around 7 to 10 years, with deficits in bad years offset by surpluses in better years.

Faster economic growth in recent years means that the economic cycle that the Treasury estimates began in 1997-98 has now probably ended and the UK has begun another cycle. Because of the bumper surpluses that the Chancellor enjoyed during the stock market boom at the end of the 1990s and some tweaking of the numbers, the Government ought to have met the Golden Rule over the previous cycle, despite heavy deficits in recent years.

The trouble for the Chancellor starts if the Treasury accepts that the UK has already begun another economic cycle. With the government running a deficit of 3.5% of the UK's annual economic output - and 1.5% even after investment spending is stripped out - in theory the Chancellor would need some large surpluses in future years to meet his rule. This is an unlikely scenario without some hefty tax rises.

In the past, the Treasury has always managed to avoid raising taxes by redefining the Golden Rule to ensure compliance, and will, no doubt, seek to postpone the inevitable again. But another awkward question for the Chancellor is why have the public finances fallen so far into the red, when growth has been reasonably buoyant?

The disclosure that the economy grew more quickly than first thought - and hence has less slack - also adds to the Bank of England's worries. The value of retail sales of goods other than food - a reasonable measure of households' spending on discretionary items rather than necessities - is growing at its fastest rate for 18 months, indicating that consumer spending is finally recovering from its slowdown last year. The housing market also appears to be enjoying a renaissance, reversing the fall in mortgage approvals over the spring. The improvement in household spending has meant that retailers no longer need to resort to such heavy discounting in order to attract shoppers. This is a concern for the Bank because falling goods prices in recent years have helped to offset stubborn inflation in the service sector. With higher utility and fuel bills pushing inflation higher, the inflation environment is beginning to look more uncomfortable.

As a result, it is looking increasingly likely that policymakers will be forced to raise interest rates as an insurance policy against future inflation. The less benign inflation outlook and the fact that UK government bond yields do not yet appear to be reflecting the possibility of an interest rate hike means that UK bonds look expensive compared to markets elsewhere.

However, the interest rate outlook and the more upbeat economic climate is good news for the pound, which should strengthen as a result.

For the moment, negative sentiment is likely to mean that UK equities continue to tread water against government bonds. However, the more upbeat economic environment ought to lift the UK market a little - particularly with economic indicators generally surpassing expectations in recent weeks. Furthermore, the fairly defensive nature of the market - dominated as it is by oil companies, pharmaceuticals, telecoms and banks - means that it should outperform markets elsewhere given the mounting evidence of a modest economic slowdown worldwide. In addition, with investment analysts fairly upbeat on the profit outlook and valuations appealing, UK equities look an attractive refuge in a nervous market

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