Monday, July 4, 2011

Watch out for a significant improvement in global growth prospects

I will be on vacation for the next weeks and restart blogging towards mid-August.

Worries about the global growth environment have intensified over the past months, mainly due to three reasons:
a) the Eurozone sovereign debt crisis and the threat of a near-term Greek default
b) the weakening of the US economy with a string of below-expectations data releases since the beginning of March
c) high inflation rates in developing economies, forcing central banks to tighten monetary policy, thereby threatening a hard landing in a host of countries, most notably China
Furthermore, the Japanese catastrophe has lead to a sharp reduciton in output, however, here most agree that this is a temporary phenomenon and the economy should rebound sharply in the months ahead.

I am convinced that over the next weeks and months, we will see significant improvements on all three fronts and hence a positive global growth environment which as of now does not seem to be priced in bond as well as equity markets.

First, the probability of a near-term unorderly Greek default has dropped substantially. To be sure, despite the second bail-out programme for Greece, the Eurozone debt crisis will not go away soon. Greece is de facto insolvent and remains mired in recession and the periphery in general will suffer from weak growth for years to come. However, the unorderly Greek default scenario would likely have resulted in another systemic crisis for the European financial sector. Furthermore, it would have likely lead bond yields in the large peripheral countries - Italy, Spain and Belgium - sharply higher. At the least this would have caused another recession in these countries but could as well result in a full blown buyers strike for peripheral sovereign debt!
But this scenario seems to have been averted for now and I expect peripheral bond markets to stabilise further in the weeks ahead which in turn should help general sentiment.
Furthermore, as I have been stating on several occasions, I expect the US economy to show an improving growth picture during the summer months. I have mentioned previously that I am convinced that the economic weakness in the US so apparent since early spring is largely down to a combination of temporary factors, most notably seasonal adjustment factors which are too large, adverse weather, high commodity prices and supply disruptions due to the catastrophes in Japan. Seasonal factors, however, are reversing as July/August is usually a weaker period for the economy. As a result, seasonally adjusted data for these two months should show an improvement vs. the usually strong spring period. Furthermore, supply disruptions have been reported to be weakening and hence production in the affected plants (and the supplier of other input goods used) should slowly move back to normal. On top, the substantial recent drop in commodity prices - just in time for the summer driving season - is equalling a rise in households real net income and hence should support consumption. Overall, therefore, I expect that US economic data will surprise positively in the weeks and months ahead.

CITI US economic surprise indicator: String of negative data is over
Source: Bloomberg

Finally, given the recent drop in commodity prices, headline inflation rates, especially in developing countries where commodities play a more important role in consumption baskets and hence in determining inflation rates, should also start to fall again. This in turn, should mean that an increasing amount of emerging markets central banks will soon reach the end ot their monetary tightening cycle, thereby reducing the threat of a hard landing. Additionally, lower commodity prices will c.p. lead to higher real incomes for households and hence support consumption growth.

Favorable base effects ahead: Agricultural commodities started to rally exactly a year ago
Source: Bloomberg

Especially prices for agricultural commodities have risen sharply since the beginning of July last year (see chart above) and the S&P GSCI Agricultural Spot Index almost doubled by mid-February this year, i.e. within less than eight months. However, since then it dropped by almost 20%. The chart below shows the year-over-year percentage changes in the agricultural index since July last year. As can be seen inflationary pressures from agricultural commodity prices have been extremely substantial. However, while at the beginning of June, agricultural prices were up 80% on a year-on-year basis, at the beginning of July, this fell to less than 50%. But even if it agricultural price do not drop any further, year-over-year price changes should continue to fall given the sharp rise which started exactly a year ago. Should prices stay at current levels, then the yearly rate of change should drop to +20% by the end of this month and to 0% by the end of September. Given these favorable base effects, inflationary pressure from high food prices should ease markedly in the months ahead, be it in the developed world and even more so in emerging markets. Even within the Eurozone, the weight of food prices in inflation is diverging widely. According to Eurostat data for 2010, the food sub-index had a weight of 10% in the overall price index in Germany. The economically challenged large peripheral countries, however, have a food price share of 16% for Italy and 17% for Spain. Hence, lower food prices should be more beneficial to the peripheral countries than the core. Typically, though, in emerging markets, food prices play an even more vital role.

Food price induced inflation pressures should drop off sharply (yoy %-change in Agricultural commodities)
Source: Bloomberg, ResearchAhead

Overall, therefore, growth prospects - be it in the US, the Eurozone, Japan, as well as across emerging markets - might well see a significant turn for the better over the next few months. Markets do not seem to reflect such a favorable scenario and equity prices as well as government bond yields appear too low. Hence, I remain of the opinion that 10y Bund and UST yields will move towards 3.75% by the end of autumn.

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