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Economics Weekly - Macroeconomic themes for 2008: another strong performance by emerging economies; Weekly economic data preview - Fed Bernanke testimony, plethora of US data, UK CPI and retail sale

Economics Weekly 14 January 2008

Macroeconomic themes for 2008: another strong performance by emerging economies

After a year of volatility in global financial markets in 2007, but stronger than expected economic growth, what will 2008 bring? The short answer from our projections is more of the same. Growth in the emerging markets, led by the big four of China, India, Russia and Brazil, outperformed the global average last year, and is set to do the same again this year, see table 1. It is clear that such an outcome will have implications for the trends of inflation and interest rates and for financial market performance in general.

Economic growth to be strong once again…

Despite the doubling of oil prices and the credit crisis, global economic growth last year was above the long run average for a fifth year in succession. It was also clear that though growth in the main economies held up very well, this strong outcome was primarily due to the emerging markets, in particular China, India and Russia. But growth was also strong in all of the major oil exporters and commodity exporters of metals and minerals. There are few signs from these economies in recent months that the pace of growth is yet slackening. Oil prices remain high and demand for commodities from the emerging market giants (in terms of population) of China and India is still strong. However, we project that higher interest rates in many of the emerging market economies and currency appreciation over the past year - and likely to persist into this year - will slow down growth in 2008 compared with 2007.

...led by emerging markets...

But with oil prices still high and commodity prices in general still strong, emerging market growth will remain broad based and not confined to the largest developing economies. Continued growth in the emerging economies will also help growth in the developed economies to stabilise at or near trend rates this year. This means growth for the UK of 2.3% and for the eurozone 2%. For the US, growth is likely to remain below trend, at some 2%, as a result of the fallout from an extremely overvalued housing market slowing down and the bursting of the credit market bubble. This should be seen as good news in the medium term as the US has been consuming too much and saving too little in recent years, which meant that it was running an ever larger external deficit that threatened the stability of the global economy. A weaker currency will help to rebalance the global economy and make growth more sustainable in the years' ahead. With continued weakness in the US dollar likely this year, we look for faster export growth and sharply lower interest rates to spur economic recovery in the second half of 2008. However, once growth starts to recover, and it is clear that interest rates have peaked, the US$ could well reverse some of its decline.

...but inflation set to remain relatively high, limiting interest rate cuts

With continued strong economic growth and high commodity prices, price and wage inflation trends should remain a worry in 2008, and imply that, particularly in the emerging market economies, there is not likely to be much easing of interest rates. In the developed economies, inflation may slow, but here too any slowdown looks likely to be modest. In fact, for the eurozone, we look for higher interest rates in the second half of 2008, as the credit crisis fades but elevated price inflation remains a concern. For the UK, interest rates will fall further in early 2008, because they were raised to a high level in 2007 and so have scope to decline, given the likely slowdown in growth. But cuts in UK interest rates will be limited by a risein imported inflation from a weakening currency. For the emerging markets, inflation is likely to remain even more of a worry because of strong growth, despite appreciating currencies, and so interest rates may remain relatively high and more likely to rise than fall.

Macroeconomic themes have interesting implications for financial market activity in 2008.

How will financial markets react to these macroeconomic trends? With strong growth and high inflation, interest rates and commodity prices, the emerging markets are likely to see continued strong inward investment flows. The emerging economies equity markets should outperform the developed economies once again, see chart c. But solid global growth should make equities in total perform strongly for another year. However, stronger than currently expected economic growth may see bond yields reverse their recent lows in developed countries and rise in the second half of 2008. This would reverse the pattern of 2007 - bond yields could fall or be low in the first half of this year and rise in the second half, see chart e.

Cash rates in the developed countries could see libor rates more closely reflect repo rates, rather than be driven by worries about credit markets. But this will only occur if the credit crisis eases, even if economic growth is stronger than expected in 2008. The latter implies that corporate bonds are oversold, as corporate defaults may not rise as much as is feared. With still robust global demand, oil prices may not fall back and demand for other commodities could also remain strong, leading even more funds to invest in these assets. Food prices may also remain higher than expected in 2008, with attendant worries about inflation and so for yield curves to shift about more. All in all, the economic background suggests that we will have another year of severe and perhaps surprising financial market volatility.

Trevor Williams, Chief Economist


Weekly economic data preview W/c 14 January 2008

Fed Bernanke testimony, plethora of US data, UK CPI and retail sales

Economic data this week will fuel expectations that the US and UK central banks will reduce interest rates further at their next respective meetings on January 29-30 and February 6-7. The key UK focus will be latest inflation, retail sales and labour market statistics. In the US, there is a plethora of data releases, including retail sales, CPI and industrial production. Policymakers will also take note of the US Empire and Philly Fed business confidence surveys, as well as the University of Michigan consumer sentiment indicator. Speakers include Fed Chairman Bernanke's testimony on Thursday on the economic outlook. The only BoE speaker is Deputy Governor Gieve. In the euro zone, we expect the ECB to resume policy tightening later in the year. Final euro zone CPI and the German ZEW survey will be the key releases, while the ECB will release its monthly bulletin. Germany will also release its first estimate of 2007 GDP.

• UK CPI inflation is expected to remain steady but marginally above target at 2.1% in December. The RPI measure, which includes mortgage interest payments, is expected to fall to 4.0% from 4.3%, see left chart below. The convergence between the CPI and RPI measure will continue in 2008, as the Bank of England cuts interest rates. Wage deals are mostly based on the RPI measure, which remains elevated. With unemployment expected to fall again, by 6,500 on the claimant count measure in December, this may partly explain the MPC's decision not to reduce interest rates at their last meeting in early January. That being said, we expect average earnings growth to remain relatively benign at 4.0%. The MPC will examine closely official December retail sales figures, which are expected to show a 0.2% rise, which would reduce the year-on-year rate to 3.5% from 4.4%. Even though unemployment is still falling, a slowing housing market and a more cautious consumer in 2008 will lead to slower economic growth. The RICS house price survey is expected to confirm softening activity in that sector. The DMO is scheduled to auction £725m of index-linked bonds.

• The US calendar is busy, with a full slate of economic data releases. Fed Chairman Bernanke's testimony on the economic outlook to the House Budget Committee on Thursday will also be examined extremely closely. Last week, Bernanke's dovish comments appeared to give the green light to expectations of a half-point interest rate cut at the next FOMC meeting on January 29-30, with a high risk of an inter-meeting rate cut. Ahead of the testimony, markets will digest PPI and CPI inflation figures, as well as retail sales, industrial production, capital flows (TIC) data and the Beige Book. The Fed will also offer a third injection of term funds through the Term Auction Facility. We expect core CPI to rise 0.3% in December, which will bring up the year-on-year rate to 2.5% from 2.3%, the highest since March 2007. Industrial production is forecast to rise 0.1% in December, though markets will also focus on forward-looking business surveys in the form of the Empire and Philly Fed surveys. Despite weak December labour market statistics, retail sales are expected to post a small monthly rise. It would appear that US consumption is holding up, though the University of Michigan consumer sentiment indicator, due on Friday, has fallen in the past year, which may presage softer consumption in 2008, see right chart.

• In the euro zone, the German ZEW survey, released on Tuesday, is expected to fall to -39 in January from -37.2, highlighting a further fall in investor confidence. However, the ZEW current situation index remains near cyclical highs and investors may be excessively downbeat about prospects. Germany will release its first estimate of 2007 GDP, which is expected to be 2.5%. Final December euro zone CPI is expected to confirm the flash estimate of 3.1%, well above the ECB's target. On Thursday, the ECB will publish its monthly bulletin.

Economic Research,

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