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Thursday April 28, 2005 - 14:58:03 GMT

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G7 growth under threat

The April evidence suggests that there is a significant risk of a slowdown in G7 GDP growth due to the impact of high oil prices, rising interest rates and a reduction in credit growth. From a longer-term perspective, there is also the possibility that the G7 industrial sector is being priced-out of global markets which could intensify any slowdown.

In this environment, there is likely to be greater caution over pro-growth strategies in the currency markets. If there is a sustained slowdown in G7 growth, the Australian dollar is likely to be vulnerable on a shift in market sentiment. Greater interest in defensive currencies such as the Swiss franc would also tend to weaken or at least limit the potential for gains in Sterling and the New Zealand dollar. The US dollar implications would be mixed as growth fears would be offset by the potential for a liquidation of carry trades funded through the US currency. This could strengthen the dollar initially, but the longer-term implications would be likely to be negative for the US currency. The yen implications would be neutral to slightly positive.

The economic data over the next few weeks could, therefore, have important consequences for the currency markets if it appears to validate speculation over a significant slowdown. It is certainly a realistic possibility that US, Euro-zone and UK growth will slow towards annualised rates of 1.0% over the second half of 2005.

Growth doubts liable to increase

The latest economic data has raised the possibility of a significant slowdown in the global economy. The data trends are still tentative, but the risks certainly appear to have increased.

Within the US, the evidence has remained mixed, but there was a significant drop in durable goods orders for March following evidence of slower consumer spending growth. The overall manufacturing evidence has been less clear, however, with strong growth in some regional manufacturing surveys. There was a slowdown in US first-quarter GDP growth to 3.1% from 3.8% previously with weaker investment and rising inventories.

In the UK, the CBI industrial manufacturing sentiment index weakened to the lowest level in close to 18 months for April and recent retail sales data has been subdued.

Within Europe, there have been monthly declines in the German IFO and ZEW indices for April while there was also a drop in French industrial production. French business confidence fell to the lowest level since November 2003 while there was also a decline in Belgian confidence. The German institutes have revised down their growth forecasts for 2005 and ECB optimism over growth is fading.

The Chinese economy is still performing strongly, but there are still Japanese vulnerabilities with a 0.3% March industrial production decline following a weaker Tankan index.

Equity markets struggling

The major stock market indices have been struggling over the past few weeks with the Dow Jones index struggling to hold above the 10,000 level. The UK FTSE index has fallen to near 2005 lows and there have been sharp falls in the secondary UK indices which suggest increased investor caution over the UK economic prospects.

Economic conditions less favourable

There is certainly an increased risk that the global economy is slowing. High oil prices will be a significant factor in slowing growth. If economies are weakening, the evidence is likely to be seen primarily in consumer sector after rapid spending growth over the past few years. Consumer spending has been fuelled by an easy credit stance, rising asset prices and strong borrowing. Following the 2000/01 technology downturn and the 2001 terrorism attacks on the US, there was a deliberate central bank decision to boost global liquidity

The central banks have now been tightening monetary policy over the past year with rate increases in the US, UK and Australia, although rates have been left unchanged in the Euro-zone and Japan. The combination of higher interest rates, falling asset prices and high energy prices would make it much more difficult for the consumers to take out fresh debt, especially as the servicing costs of existing debt will increase. Slower liquidity growth will also increase the global growth risks.

It would be wrong to make to much of the position at this stage as any slowdown could prove to be temporary, as was suggested recently by Fed Governor Yellen. The economic data released in May is likely to be scrutinised very carefully for evidence of a more sustained slowdown.

Switch to China?

There is the possibility that weakness in the G7 industrial sector reflects an increasing market share by China and other emerging markets. The lower cost base and competitive exchange rate position due to the weak dollar will have encouraged a switch in output to China. The Euro-zone and UK economies will be particularly vulnerable to these relocation pressures as they have suffered a significant loss of exchange rate competitiveness over the past two years. Sterling, for example, has strengthened by close to 20% against the yuan over the past two years with strong gains for the Euro as well. With rising non-wage cost pressures, the attractions of China and other low-cost bases will be compelling.

Europe will also be vulnerable to a switch in production to Eastern Europe, particularly with the EU expansion which now encompasses important former communist economies. There will be greater optimism over the political framework and there have also been tax reforms to boost inward investment. It is certainly, therefore, possible that production shifts will exacerbate any G7 growth downturn.

Growth strategies at risk

There will be further interest rate increases by the US Federal Reserve, the Bank of England will consider a rate increase on inflation concerns and the ECB has ruled out a rate cut. Global monetary conditions are, therefore, likely to be tighter over the next few months. Overall, a period of weaker growth looks to be a strong possibility, especially given the need to unwind over-extended consumer debt levels.

A synchronised slowdown should have only a limited impact on the main currencies as relative prospects would be little changed. Indeed, there is a evidence of a significant loss of confidence in US, Euro-zone and Japanese growth prospects. There would, however, still be significant currency implications if there is a sustained slowdown. In this environment, there will be considerable dangers in growth currencies such as the Australian dollar. Any weakness in consumer spending would also tend to erode support for the US and UK currencies with greater interest in defensive currencies. Emerging-market yield spreads would also be likely to increase which would certainly slow the potential for currency gains.


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