Global Markets Weekly - 21st December 2007

• We outline some potential themes which lie outside our central forecast.
  Our 2008 Outlook, published earlier this week, details our central forecast of a sharp economic slowdown in the first half of the year followed by a recovery to moderate growth in the second half. It also outlines two risk scenarios. Here, we consider ten potential ‘surprises’ that could affect markets during 2008. We stress that we are not forecasting any of them, and this list is not exhaustive, but we hope they will prove thought-provoking. Please note: Global Markets Weekly will next be published on 7th January.
• Sovereign wealth funds make their presence felt.
  The move to real return strategies within foreign exchange reserve portfolios will lead to a large shift out of government bonds, especially Treasuries. China has sold Treasuries for each of the past four months. Over recent years, foreign purchases of Treasuries have subtracted 50 to 100 basis points (bps) from US real yields. If foreign buying of Treasuries dries up altogether, that would push up mortgage rates, kicking a US housing market which is already on the floor.
  
• Tensions thaw – Libya, North Korea…Iran?
  Violence in Iraq has lessened significantly over the past few months, and US and Iranian diplomats have met in Iraq on several occasions, most recently last week. Russian supplying of ready-enriched uranium to Iran with the blessing of the US could form the early stage of a grand bargain between the US and Iran, which politicians in both countries have been increasingly vocal in pushing for. Iran would gain diplomatic recognition and much-needed western technology in return for cooperation in Iraq and favouring US oil companies. Slower G7 growth, Iran-sponsored OPEC quota increases and reduced risk of supply disruption could combine to take the oil price considerably lower. An oil price of around $50 a barrel would give global growth a major boost in 2009.
• Dormant since the 1930s, the ogre of protectionism reappears.
  A number of US presidential candidates are openly opposed to free trade, portraying the North American Free Trade Agreement (NAFTA) and the World Trade Organization (WTO) as destroyers of US jobs. Rising unemployment in 2008 is likely to provide a firmer hook for this populist message and could result in tariff legislation. That would remove a key dynamic of global growth and, as other countries responded with their own tariffs, global growth would slow dramatically.
• China slows – and commodity prices take a dive.
  The Chinese authorities are pulling all available monetary levers to slow the economy, most recently increasing banks’ reserve requirements to 13.5%. With growth slowing in the US – China’s largest export market – Chinese policy-makers should be careful what they wish for. Food price inflation is draining domestic consumers’ wallets, and even the boost from 2008 Olympic spending will soon be gone. Slowing G7 growth has already pushed copper to a nine-month low. Add in downside growth surprises in China, and the commodity price boom of recent years could be the next bubble to burst.
• Plummeting house prices lead to financial re-regulation.
  Most European and US voters are owner occupiers, and falling house prices lose elections - just ask George Bush Senior or John Major. As central banks have managed to overcome their initially laissez-faire attitude to the credit crisis, so governments could actively address household balance sheets. The US government has already started down this path. However, with government aid comes government regulation: red tape intended to curtail the speculative excesses of recent years would produce lower, if possibly more stable, growth and hit bank earnings.
• Plaza Accord II? Concerted action weakens the dollar against Asian currencies.
  The US faces a large current-account deficit and recessionary growth conditions. Despite some weakness, the dollar still looks overvalued relative to its major trading partners in Asia. That’s right: it’s autumn 1985, and ‘St Elmo’s Fire’ by John Parr is No.1 in the US charts. Meanwhile, in New York’s Plaza Hotel, Japanese, West German and US policy-makers, faced with the potential of a dangerous and uncontrolled dollar collapse, agree to intervene to
  depreciate the dollar against the yen and deutsche mark. Over the next two years, the dollar falls 50% against the yen, and the Plaza Accord is generally seen as a success.
  
  Moving forward to 2008, now that central banks have got a taste for intervention in cash markets, might the rest of the world consider the renminbi’s revaluation too important to leave to the Chinese to manage alone?
• Asian assets ‘melt up’, as the region's stocks mirror the 1990s tech bubble.
  In 1998, responding to the collapse of Long Term Capital Management (LTCM) and the Russian default, the US Federal Reserve (Fed) slashed interest rates by 75 bps. But growth was already strong, and technology stocks were heralded as a new paradigm. The result was the tech bubble, the bursting of which still haunts investors. Today, Asia faces that same bubble-inflating triple-whammy of rate cuts, strong growth and investor belief in a new paradigm (for ‘tech’ read ‘decoupling’). From the time of the first Fed rate cut in 1998 to its peak in 2000, the NASDAQ soared 165%. Since the Fed cut its primary discount rate in August 2007, emerging Asia stocks have risen 24%. Could it be that the Asian rally has only just begun?
• Inflation targeting is so 1990s – could targets go the way of fiscal rules?
  Rising commodity prices, especially for food and energy, are driving up inflation and straining consumers’ wallets the world over. With growth simultaneously slowing, the commitment of inflation-targeting governments to the regimes they created in the ‘goldilocks’ 1990s is likely to be seriously tested for the first time. In recent years, many governments have shown scant commitment to fiscal rules when they have been tested. Faced with the prospect of a serious downturn, are they likely to show inflation targets any greater respect?
• Cash market goes cold turkey – short-term pain brings a brighter outlook.
  Central banks are still behaving as though pumping out liquidity will un-glue cash markets. Yet liquidity shortages are a symptom of underlying credit concerns. If investors still do not trust investment banks’ disclosures after their end-of-year statements, what will central banks do then? The logical continuation of present policies would result in the European and US banking sectors depending on central bank funding for survival – Northern Rock writ large.
  
  However, rather than effectively nationalising their banking sectors, central banks could switch to a policy of ‘cold turkey’, leaving banks to solve their problems on their own, with no further injections of liquidity to help them out. They would be more likely to try this approach if governments and sovereign wealth funds were stepping in to address the root of the problem with new capital. That would mean a short, sharp shock for cash and credit markets, but it would hold out the prospect of better times ahead.
• German reform reversal – the political pendulum swings.
  Over recent years, the German economy has produced a powerful, export-led recovery. The Agenda 2010 and Hartz IV reforms introduced in 2003 helped to contain wage costs, improve competitiveness and widen margins. Now, however, the political pendulum has swung back, with debate turning to how far these reforms should be undone. In a slowing
  growth environment, any reversal would be very dangerous. Is Germany getting ready to throw away its hard-won successes? 

Charts of the Week

 
Indices, Interest rates and Inflation

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