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Economics Weekly: Global growth to slow in 2007 but remain robust, Weekly economic data preview: Could the Bank of England hike rates this week?

Economics Weekly:

Global growth to slow in 2007 but remain robust
After a third consecutive year of above trend growth in 2006, the world economy is set to remain strong in 2007. However, the rate of growth is likely to slow, with the biggest adjustment taking place in the developed economies, in particular the US and the EU economies. The global slowdown should not be exaggerated though, with expected growth of 4.6% after 5.1% in 2006. Of the G7 economies, we expect the UK to be the only country in which growth accelerates this year. Global price inflation is expected to fall back in 2007, as a result of higher interest rates in 2006 and this year. Short term official interest rates are not expected to fall substantially until 2008. Financial markets, though not perhaps bonds, might like this profile, with equities possibly showing a record consecutive fifth year of rises as bond markets fall back. Off the back of continued healthy growth, we look for corporate profits to remain strong (boosting business investment) and corporate defaults to remain low, whilst spreads widen only modestly. However, we still see some risks, from higher oil prices and trade imbalances for example.

Growth to remain strong in 2007?
On what basis are our expectations for firm growth in 2007 founded? The short answer is that real interest rates remain low despite the rise in nominal short term rates and fiscal policy is still mostly expansionary. Recent consumer and business confidence trends show that prospects for business investment spending have strengthened globally, whilst consumer spending is likely to be maintained, albeit at relatively modest levels. Share prices are up and housing markets are still strong, with the US the exception to the latter at present. Hence one big global risk stems from the US housing market, where a sharp slowdown is underway. However, we believe that this slowdown will only modestly lower the overall growth rate of the US economy.

The reason is that continued growth in employment and rising real incomes will help sustain consumer spending. If we are correct, and equity market gains hold up in 2007, boosting personal wealth, then that too will act to protect overall consumer spending in the US. This is the example of the UK and Australia housing markets, which fell but are now recovering again without either a collapse in house prices or a fall in consumer spending having occurred. Indeed, their experience suggests that there is in fact an upside risk to US economic growth, if the housing market there bounces back quicker than anticipated. Recent US housing starts and mortgage applications data suggest that a trough has already been reached.

New themes are emerging
Profits are still holding up and stock building is not excessive. Investment spending is now recovering. There are three other key trends that we see emerging in the world economy this year from the pattern of economic growth shown in table 1. There will be some rebalancing of economic growth from over reliance on the US to other developed economies and continued fast growth of the emerging markets. In consequence, there will be some shrinkage in current account deficits in the US and UK and a fall in the surpluses of China and the emerging markets generally, see table 1.

The recent fall in oil prices is good news for the growth of the global economy and for inflation trends in 2007. This will help prevent interest rates from rising much from current levels in most economies and encourage rate cuts in early 2008 or late 2007 in the UK and the US. In the EU, however, interest rates are still likely to rise modestly higher as the ECB returns monetary policy to a more normal level after many years of being abnormally low. Global interest rates, however, remain low in real terms in historical perspective, as well as in nominal terms. Emerging market growth, helped by still high oil and commodity prices will remain firm, as the exceptional growth of China, India and Russia, and a range of other emerging markets, continues. The world economy is now an emerging market, US and EU story, rather than simply a developed country story. China could even pass Germany in the next few years to become the world’s 3rd biggest economy.

The UK outlook
Despite higher official base rates since August last year and one, possibly two more increases this year, UK growth is expected to be particularly robust in 2007 compared with that of the developed economies generally. This is due to the strength of its services sector, which is benefiting from fast growth in global financial markets. Moreover, UK business investment is finally picking after years of weakness. Faster growth in the world economy will encourage this process, as UK manufacturing companies emerge from recession and benefit from above trend growth in the EU and the emerging markets. Consumer spending growth in the UK will likely remain low by historical standards, rising by just 2.5% in 2007 after 2% in 2006, as higher utility bills and record debt levels weigh on spending. However, falling unemployment and some increase in wage inflation will help to maintain real income growth and so consumer spending.

Risks remain
There are as ever risks: from higher oil and commodity prices; the US housing market could fall more sharply; there could be a big credit crisis, and an act of terrorism, but overall the prospects for the global economy are for above average expansion in 2007. The main internal risk for Europe comes from Germany after the vat rise, but the portents look good, with unemployment down and employment rising. German sentiment and gdp growth fit well together, and confidence is up very strongly. Currency volatility is another potential issue but we expect the dollar to hold up and to remain fairly stable, see table 2.

Financial markets could be volatile in 2007
We believe that 2007 could be another good year for financial markets based on the growth and inflation trends described. Bond market yields remain very low and so may correct, given the likely robust pace of economic growth, and hence no significant cut in official short term interest rates, see chart a. However, with inflation still remaining low by historical standards, any corrections need not be too dramatic but yields could still be 50 to 100 basis points higher in some markets. Equity markets, rarely, if ever, rise for 5 consecutive years yet this is the position that many are currently in, see chart b. There could be some fall back from recent high levels, even if growth and profits turn out as expected.

Trevor Williams, Chief Economist

Weekly economic data preview

Could the Bank of England hike rates this week?

• Recent UK economic data have been surprisingly strong and have raised financial market expectations that the next move in interest rates will be up. Although the MPC voted unanimously to maintain interest rates at 5% in December, there appears a real risk that some members may be swayed by the latest economic figures and could advocate an increase to 5.25% this week.

• Although the ECB is widely expected to keep the refi rate at 3.5% on Thursday, the press conference will attract significant market attention as financial markets assess the outlook for policy in 2007. Euro zone economic data have been robust of late and ECB president Trichet could signal further tightening ahead. We forecast interest rates could reach 3.75% by the end of Q1 2007.

• After the better than expected US payrolls report last week, the dollar could find further support from economic data this week. The trade deficit, on Wednesday, is forecast to have stayed below $60bn for a second successive month in November, and retail sales are likely to have risen strongly again in December. Our view remains that US interest rates will not be cut in the first half of 2007.

We remain of the view that the next increase in UK interest rates is likely to be in February, coinciding with the publication of the Q1 BoE Inflation Report, however the risk of a surprise rise at the MPC meeting this week has grown. Although the MPC voted unanimously to keep interest rates at 5% in December, after 0.25% increases in August and November 2006, the continuing robustness of economic data since that meeting could have swayed opinion. The last time the BoE raised interest rates in January was in 2000, to 5.75%, after hikes in the preceding September and November, and interestingly they also hiked again in February 2000. Current BoE governor Mervyn King is the sole remaining member of that committee. Last week's data showed that housing market activity picked up further in November, with the BoE reporting that mortgage approvals and net secured lending rose to levels last seen three years ago. If activity is sustained at around these levels over the coming months, then annualised house price inflation could accelerate towards 20% in the summer. The concern on the MPC will be what this may mean for consumer spending and UK economic growth in 2007. The news that the services PMI rose to a near-decade high of 60.6 in December, from 59.8 in November, also surprised financial markets last week. The index averaged 59.9 in the final quarter of 2006 and is consistent with services output growth of over 1%, suggesting that total quarterly output growth has been above the UK's long-run trend rate in each of the last five quarters. With inflation currently running well above the BoE's 2% target and signs that inflation expectations have also picked up again, it would be a real surprise if this week's MPC meeting did not centre around a discussion of the merits of an early hike in interest rates. Although we believe that the MPC will opt to wait until February before raising interest rates and incorporate the analysis and latest forecasts provided by the quarterly Inflation Report in their final judgement, the decision to keep rates on hold this month is unlikely to be unanimous. The January MPC meeting minutes are released on 24 January. UK data released this week are few. The external trade report, on Wednesday, should show the goods deficit remained around £6bn in November, but the risk is that it could be worse as the currency has been strong.industrial and manufacturing output (released on Thursday) declined surprisingly sharply in October, by 0.8% and 0.4% respectively, however we forecast a modest rebound in November based on the PMI survey. The BRC retail sales monitor, on Tuesday, will provide an early steer on how high street sales fared in December.

The ECB is expected to keep interest rates pegged at 3.5% on Thursday. However, financial markets will be alert to any hawkish comments from ECB president Trichet at the press conference. Recent economic data from the region have been strong, especially from Germany, and interest rates are forecast to increase in the months ahead. We look for them to reach 3.75% in Q1 and to finish the year at 4%. Key data from the EU-13 are limited and unlikely to be market moving this week.

The dollar rallied against its key counterparts last week and could consolidate its gains after some early signs suggesting that the US economy in 2007 may prove more resilient than some forecasters had expected. The US trade deficit, on Wednesday, is forecast to have stayed below $60bn for a second consecutive month in November and retail sales, on Friday, are expected to show another strong increase in December.

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