Growth Slowdown, But No Double Dip

- Global "We are downgrading growth forecasts for several key countries, notably the U.S., China and Japan. Nevertheless, we believe a double dip is unlikely — a long period of sluggish industrial country growth coupled with emerging market outperformance is more likely. The Fed, ECB, BoE, PBOC and BoJ are all likely to keep rates on hold to the end of this year, whereas previously we expected the PBOC to hike once in H2 this year."
- United States "Near-term growth estimates continue to edge lower on weaker financial conditions and new signs of a hesitant consumer. Federal Reserve officials remain relatively upbeat but have acknowledged the possible need to reenergise accommodation efforts if the labour market relapses or inflation forecasts slow in an environment of less supportive financial conditions. Barring an unlikely breach in confidence, a healthy business sector and stabilising credit conditions should support continued moderate recovery with low interest rates well into 2011."
- Euro Area "Available data signal a stronger-than-earlier expected increase in 2Q GDP. However, the 2Q reading is overstated by temporary factors and we expect a slowdown in growth in 2H. Broader-based fiscal tightening partly is responsible for the growth moderation. With the reduction of liquidity, the ECB has started the “normalisation” of monetary policy. While we do not expect an increase in the policy rate before mid 2011, money market rates have already started to go up."
- China "The economy began to show more signs of weakness at the end of the second quarter, with lower growth and less threatening inflation. Policy could turn to a more neutral stance, while outright easing may still need to wait for a deeper downturn to materialise. We revise down our growth and inflation forecasts on much weaker momentum, and no longer expect the PBOC to hike rates again in the rest of this year."
- Japan "Economic policies including concrete discussions about a consumption tax hike will likely stagnate with political decision-making expected to become dysfunctional in the wake of a setback for the ruling coalition in the Upper House elections in July. In this context, speculation has increased that more burdens to support the economy will be on the Bank of Japan."
- United Kingdom "Inflation is likely to remain sticky and above target for a while, reflecting the lagged effects of the weak pound and rising capacity use. The fiscal deficit has started to fall versus year-ago levels and is likely to fall much faster than the consensus expects."
- Canada "Robust domestic demand and rising inflation expectations warrant further modest policy tightening nearterm. However, increasing uncertainty about global prospects and intensifying downside risks from abroad obscure the outlook. We maintain our expectation of a gradual unwind of extreme accommodation, but now anticipate a policy rate of 2.50% in 2Q 2011 followed by a lengthy pause."
- Australia "The economy continues to perform robustly but, given global uncertainties, and with lending rates already back to average levels, we expect only one further rate rise before year end."
- Emerging Asia (ex China) "Economic momentum seems to be peaking, with exports and investment upturn to taper off on global uncertainties. Inflation has remained manageable for most, but Asian central banks still generally surprised with their earlier-than-expected policy normalisation — as is the case in Taiwan, Korea and Thailand — while India and Malaysia continued on their series of hikes. Robust long-term growth prospects remain intact. We still think Asia’s REER appreciation will persist in the longer term."
- Latin America "The peak of growth rates probably lies behind us, as we expect a deceleration of growth in 2H 2010 in most countries in the region. We have nevertheless not changed our policy rate forecasts, although risks lie on the side of smaller hikes in the case of Brazil for the September meeting."
- CEEMEA "The 2H slowdown that we have been expecting is here and we leave our main forecasts the same as last month's save for some 'housekeeping' updates. Fiscal consolidation plans remain a risk in some key countries — Hungary, Ukraine, Poland, for example. We haven't changed our policy rates outlook, but in general it seems that central banks are probably now more keen to stay accommodative for a longer period."
Citigroup Global Economic Outlook Strategy July2010

A stronger JPY recently: the prelude of a competitiveness policy by China?

- "The Japanese yen has strengthened significantly in the last few weeks to the strongest level in the year against the USD."
- "Fundamentals in Japan remain conducive to strong JPY, due to structural current account surplus. The new situation of very low interest rates worldwide has de-facto annulled the possibility of strong carry trades, such as the ones that weakened the JPY between 2005 and 2007."
- "Against this already very conducive environment, the recent strengthening has been coincident with the announcement and implementation of the new CNY exchange regime."
- "In this paper we argue that today’s and tomorrow’s stronger JPY might be the
result of an economic policy strategy by the Chinese central bank (PBOC), which aims at preventing further loss in competitiveness for Chinese goods. If this is the case, there is a risk scenario on our central JPY forecast which would see the yen much stronger in FX markets against the USD and the CNY."
Natixis Flash Economics 366 20100716

Adjusting to the new regime

- Overview: "Additional Fed easing measures are likely to be required to tighten the UST-Bund spread further."
- "Scope for significant yield curve steepening may be limited by recent rises in Libor rates."
- US Rates: "With yields significantly below our fair value levels we look at ways to gain exposure to an upward correction; 2s10s steepeners in UST remain correlated to a short duration trade but carry better than outright shorts."
- Euro Rates Strategy: "We recommend taking off short peripheral and fundamental-based spread positions in the current environment of positive news, buoyant mood, and supportive technical factors. There are, however, some remaining relative value opportunities which we highlight."
- Sterling Rates Strategy: "Recent bull flattening of the 2s-10s gilt curve is consistent with anchored short rates, declining inflation and supply expectations and the ongoing grab for yield. We see both 2s-10s and 10s-30s as being close to fair value. However, going forward we expect to see the longend outperform. This should reflect in higher levels of yield curvature."
- Global Inflation Strategy: "The combination of positive cashflows and a large month-end extension should bring much needed relief to euro break-evens in the week ahead. UK real yields are under pressure ahead of supply."
- Index-linked Index Projections: "We project a duration increase of 0.43 in the EUR ILSI at the end of July. There have only been three bigger monthly increases in the last three years."
- APAC Rates: "In Japan, we like 2yr forward 5yr/15yr – 5yr/20yr curve flatteners in swaps or in conditional space."
- "In Australia/New Zealand we find little value in receive AUD versus pay NZD trades, unless the RBNZ hikes by more than 150bps relative to the RBA."
- End-July EGBI projections: "We expect only a small duration increase in the EGBI at the end of July. Projected index changes point to support for Germany, Spain, Italy and France."
Citigroup International Interest Rate Strategist 20100722

Pan-European:Growth Over Size - UK:Japanese Style

- Pan-European — Growth Over Size
• Size matters — Mega- has underperformed mid- and large-ex-mega-cap in both rising and falling markets. Growth concerns and lack of inflows have been a headwind.
• Mega appeal — We are happy to own mega-caps exposed to our key investment themes: (1) growth and (2) B/S strength & quality, e.g. BHP, Novartis & ABB.
- UK — Japanese Style
• Mega cap still underperforming — UK mega-caps lag again despite earnings, yield and balance sheet support. Liquidity favours mid- and large-ex-mega-caps.
• Give up or get even — With flows weak, the best chance of outperformance comes from either retiring mega-cap equity or breaking up the mega-caps.
Citigroup European Portfolio Strategist 20100722

Germany’s austerity package and the federal budget

- "Germany has presented a four-year consolidation package to reduce its structural deficit and bring cumulative budget relief of over EUR 80 bn (65% via spending cuts and 35% via revenue increases)."
- "Spending cuts (above all in the labour and social security budgets) will make up the lion’s share of the package, whereas tax hikes and subsidy reductions will play a smaller part. Taken together, the spending cuts and revenue increases foreseen for next year will amount to less than 0.5% of GDP. Moreover, the budgets for key growth areas such as education and research will remain unchanged."
- "The package will put larger burdens on airlines, energy utilities, banks and energy-intensive producers, with the proposals still needing to be detailed in draft legislation by the responsible ministries."
- "The government’s legislative proposals – presumably in the shape of a budget accompanying law – will not be tabled until autumn at the earliest, with the Bundestag probably also not voting on them until the budget debate. The cabinet’s recently adopted draft budget for 2011 and financial planning no doubt already at least specify the totals for revenue increases and expenditure cuts."
DeutscheBank Research Briefing 20100721

The Greek situation in the light of the Argentine 2001 crisis

- "Many observers and analysts have compared the Greek 2010 crisis to the Argentine 2001 crisis, in an attempt to evaluate the most probable outcome. As we know, the Argentine crisis led to the country’s default."
- "For example, it has recently been argued that as the scale of Greece’s deficits and imbalances (especially budget and foreign trade deficits and the public debt ratio) are much worse than Argentina’s situation in the early 2000s, the prospect of insolvency is much higher in Greece (N. Roubini, “It is time to face reality over Greece’s debt”, Financial times, 29/06/2010)."
- "This paper will examine the similarities and differences between the two sovereign crisis, to highlight the specific nature of the Greek crisis. We believe that the probability of a Greek debt default depends primarily on the recessive spiral in which the Greek economy is mired today. At the same time, the existing differences between the two crises may help to avoid the
probability of a Greek default. In fact, the specific nature of the Greek crisis and the probable consequences of a default on the European financial system are powerful incentives to avoid this occurrence through a much-better cooperative solution than in the Argentine case."
Natixis Flash Economics 365 20100715

If the objective is to reduce fiscal deficits, would it be better to hike taxes or cut public expenditure?

- "The euro-zone countries and the United Kingdom have undertaken to quickly reduce their fiscal deficits. Would it be better i f they did so primarily via a tax hike or via a cut in government expenditure?"
- "To answer this question, we must in our view start off from two observations:
· the reduction in fiscal deficits will seriously affect growth, unless households consume more; in the usual literature about Ricardian neutrality, this requires that only cuts in government expenditure are used; there is then a fall in expectations of future taxes and a rise in
consumption. In practice, the choices can be more complex: spending cuts that would give rise to precautionary savings must be avoided (reduction in the generosity of pension schemes and health insurance); and the same goes for tax hikes that would reduce consumption (VAT, welfare contributions paid by wage earners);
· the main problem for the European economy is the high level of structural unemployment and the sluggishness of potential growth. It is thus important to avoid tax hikes that would discourage employment (welfare contributions) or investment (welfare contributions, taxes on company earnings) in countries where companies have financial problems."
- "We are then left with the following approaches to reduce fiscal deficits:
· a higher taxation of unearned income, which is primarily saved;
· a reduction in nonessential welfare transfers (for example coverage of less serious diseases, whereas coverage for serious health risks must be maintained to prevent precautionary savings);
· higher taxes on inheritance, which would reduce the savings rate;
· raising the retirement age, which reduces the incentive to save."
Natixis Flash Economics 364 20100715

Stressed but not distressed

- "Eurozone GDP likely rose strongly in 2Q, by at least 0.6% qoq. The rebound mostly reflects an export-driven surge in IP, while construction activity bounced back after the cold winter. Private consumption remains the weak spot. GDP growth should slow substantially in 2H, probably to 1% annualized, but the risk of a double-dip recession is low."
- "While we await results of the stress test to be published on 23 July, we elaborate on recent dynamics of aggregated balance sheets of the eurozone banking system, highlighting some of the differences across national banking sectors. We show that the recent banking crisis has provided incentives to significantly improve the quality of banks’ balance sheets. However, the difficult heritage of the crisis in terms of credit losses and weak economic prospects will keep weighing on banks’ profitability in the coming two years. In this context, remnants of fears regarding the potential impact of the sovereign debt crisis could persist."
- "Since the beginning of the year, Greece has significantly squeezed primary and capital expenditure, exceeding the target for the general government deficit agreed with the EU/IMF. Against these resolute fiscal consolidation steps and persistent financial woes, it is not surprising that the domestic economy has been hit severely. Growth indicators suggest that the recession is indeed deepening, but the GDP contraction should not be more severe than projected by the IMF."
- "The June inflation slowdown should be short lived, and consumer prices will probably accelerate again in July. Energy remains the main source of volatility. Food prices, despite being up only 0.2% yoy, have entered a moderate upward trajectory that seems increasingly well established."
- "The recent upward trend in short-term rates doesn’t worry the ECB, given that the move is fully driven by a drop in excess liquidity as banks are bidding less funds than the ones expiring. We analyze two possible scenarios for interbank rates and the ECB strategy after the publication of the stress test results."
- "Growth momentum in the UK probably accelerated in 2Q, but this is likely to be a cyclical peak, as growth should decelerate in the second half of the year. The fiscal tightening will negatively affect GDP over the next few years, although it won’t derail the recovery. Against this backdrop, it is unlikely that the BoE will hike rates before the end of the year and we are postponing the start of the tightening cycle to 1Q 2011."
- FI: "The summer months are usually characterized by reduced activity and low traded volumes. Seasonality suggests that this is a good time to invest in FI but, with yields very low, statistical evidence should be taken with a pinch of salt. Also, stress test results will be a key driver affecting FI returns in the near term."
- FX: "Fears that the US recovery may prove more sluggish than expected offered the EUR-USD temporary relief, but the global risk picture remains cloudy and EMU woes have not disappeared. Hence, while EUR-USD may still hold the line during the rest of the summer, its medium-term prospects are still skewed to the downside, although room for a large drop has declined significantly."
Unicredit Euro Compass July2010

What should be done with fiscal deficits if growth becomes very weak in the euro zone?

- "It is possible that growth may become very weak in the euro zone in the
second half of 2010 and in 2011:
· if growth slows down in the United States, which may be feared based on recent figures;
· as a result of the drastic reduction in the fiscal deficit decided on in the United Kingdom;
· due to the decline in real wages and the rise in the household savings rate;
· due to the sharp reduction in fiscal deficits in those euro-zone countries which have no choice because they are under pressure from financial markets (Greece, Portugal, Ireland, Spain);
· as a consequence of offshoring, deindustrialisation and the low level of corporate investment."
- "The question that then arises concerns the attitude that should be adopted regarding their fiscal deficits by those countries that have no major obligation to reduce their deficits immediately: Germany, France, Italy, Netherlands, Belgium, Austria and Finland."
- "If euro-zone growth were to become very weak, it would of course be reasonable for them to put off a reduction in their fiscal deficits, but:
· will they want to do so (attitude of Germany)?
· will they be able to do so (possible negative investor reaction to a failure to reduce deficits)?"
Natixis Flash Economics 363 20100715