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Wednesday January 18, 2006 - 17:15:12 GMT
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2006 The Year of the Global Slowdown?

2006 The Year of the Global Slowdown?

It is on everyone's mind and in many forecasts...oh the slowing of the global economy in 2006 - or more specifically the slowing of the US and Chinese economies. The path there is high energy prices (oil is approaching $70 a barrel again), softening US housing sector and an American consumer increasingly pondering a rather novel behavior - saving. China on the other hand is talking deflation risks...disinflation is picking up and any significant slowing in exports to the US (and EU) could bring trouble for the second engine for growth.

The slowdown view augers well for US fixed income, poorly for US stocks and bad for the dollar. But is it actionable now?

While appealing, this view has some serious flaws. First of all the US housing market is not grinding to a halt. Rates never rose enough to really squeeze households exposed at the short end of the curve to exotic mortgages, variable rates and home equity lines of credit. Moreover, with US inflation well behaved at the core level, it is hard to see the Fed taking rates significantly higher. The FOMC is also keenly aware of the risks a spike in rates could bring to households and hence will be very deliberative over future rate increases beyond Jan31 likely hike.

Then there is the surprise factor of 2006...Japan and Europe appear to be growing with a domestic kicker not visible in prior unfulfilled recoveries and attempted recoveries. But there is growing evidence that domestic demand has been awoken and the slumbering giant could prove a destination for US and Chinese exports, softening any headwinds posed by housing sector fatigue, energy prices and weaker consumption.

US firms are also in quite good health, executive compensation aside. One can expect business spending to pick up some of the slack from softer housing market and its corollary - softer consumption. US firms are lean and mean, outside the auto sector, and ready to compete globally. Sure the dollar could be a little lower, though it is a lot lower against Asian currencies, excluding the yen, and Latin American currencies.

And while Washington rhetoric over controlling government spending is at the highest pitch in many years, there is little being done to trim spending net net. Sure cutting welfare, education and Medicaid helps, but not when outlays rise for other programs. Corporate and agricultural welfare entitlements remain sacrosanct. And then there is the cost of the war on is showing no sign of abating, while Medicare prescription drug benefit costs are starting to pile up. We remain in a twilight of big government. While the bills will have to be paid later, as long as foreign capital flows into the US remain high ((Korean central bank showed a nearly $5bln rise in FX reserves for the first two weeks in January), the prospect of budget deficit worries driving US rates up looks remote. Indeed the financial market still seems to believe in the abject lies of supply side cuts yield higher tax receipts. So the G in C + I + G + X = GNP looks to stay strong.

Regarding Iran, I think it is very unlikely to escalate into military conflict. Sure a stalemate on Iran's nuke program is in the cards near-term, neither Iran nor the US can afford a war, even with US troops on the ground in Iraq, neighboring Iran...indeed because they are on the ground in Iraq in a situation that appears years from a reduced US presence. Also any attempt by even Israel, much less the US, to attack Iran would drive a permanent split between the West and moderate Islamic states like Saudi Arabia and the faux democracy in the still influential Egypt. Not even a ideologically driven executive branch is eager to take this path. So I see Iran largely as a diplomatic, albeit intensely so, problem. Hence it is not the source of a spike in energy prices and a derailing of the global economy.

Dare I say that there is more potential, in the sphere of possible catastrophic outcomes, for bird flu or a financial system melt down than war driving a global slowdown in 2006. If the regulators are doing their job then credit derivatives will do what in theory they are intended to do - spread risk, reducing fallout from default and price volatility. If the banking system has found ways around regulators to extend credit to boost income and shareholder value without adequate safeguards, then we could see a real hit from the banking system...result of years of ultra low nominal rates leading to inordinate risk taking...customers demand it and banks supply it.

I will leave bird flu to the experts.

One other "tail event" risk to the global economy is protectionism. Given that the two main proponents of it in the US Congress are full of plenty of hot air, I do not see this getting very far in 2006 - China too could dampen it with another reval or widening in the tolerate daily FX band for dlr/yuan.

So some slowing in the global economy is likely this year, but a significant slowdown that would drive a major move down in the dollar may not be forthcoming. And at that measurable slowing could make an appearance later than sooner - in the second half of 2006. So dollar bears are likely to have to feed on US imbalances and rising rates in Europe as well as an end to quantitative easing in Japan (with distant hopes of rate increases) to get the dollar down. Some how this strikes me as making of a dollar top, not the bear trend many are starting to bet on. I doubt even a pause from the Fed in March will generate a major bear trend in the dollar.

For the time being I am fairly sure that the dollar is stuck in a wide range and the market is a bit too negative on the dollar...too early in expecting a downturn in the US expansion. That said the notion that the Fed will be forced to respond to an overheating economy by moving to restrictive from neutral is not in the cards and arguably necessary for any chance of a dollar rally to new highs (above 2005 highs).

David Gilmore


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