This week the markets face an even sterner test with the release of a swathe of important first line economic data in the United States including the all important first estimate of that country’s real GDP, coupled with base rate decisions from the Federal Reserve and the Bank of Japan.

Ahead of what could prove a momentous week we think it pretty safe to say that, when the dust has settled, it won’t be the Bank of Japan that everybody’s talking about!

We have, for some time, argued that the US economy is already in recession and that it probably entered recession in December of last year. We will know whether we’re right or not on Wednesday at 13.30pm BST!

Crunch time for US real gross domestic product has arrived

In a moment of heroic (and possibly mis-placed) optimism we forecast that US GDP will increase by 1.2% over 2008, having grown by 2.2% in 2007 and 3.3% in 2006. If the US economy is to get anywhere near our number a huge weight of expectation must be placed on the country’s export sector. Certainly there are some grounds for guarded optimism. Net external demand is indeed likely to be the major driver of activity over the year and Q1 2008 has already been characterised by a marked improvement in the country’s underlying trade deficit. That said, we accept that this improvement has been offset in part by the higher price of imported oil.

Elsewhere, the fall-out from the credit crunch continues, a litany of downbeat economic data weighing on consumer confidence and expenditure. In its recent assessment the International Monetary Fund broke free from its guarded reputation to indicate that, in its view, the potential losses emanating from the sub-prime crisis and ensuing near-collapse in the US financial system could cost nearly $1,000bn.

Although a number of this magnitude looks big it is, in fact, quite small in relation to its share of GDP, particularly in the context of earlier financial crises and the fact that the pain is being shared between the US and Europe.

The real problem is that it is likely to take months and possibly, if the pessimists are right, years to unwind the mess created as a result of the build-up of speculative excesses over the past five years. As the highly regarded economist Mr Roger Bootle has observed “the umpteen billions of dollars which have been magicked out of nowhere must return from whence they came”. In a week in which the Bank of England followed the Federal reserve’s suit and announced its unprecedented “special liquidity scheme” and the Royal Bank of Scotland unveiled a £12bn rights issue, the largest ever by some margin, it is entirely obvious that the financial sector is struggling to squeeze the genii back into the jar and that in so doing there will be pain for everybody.

Although the Federal Reserve is now entirely focused on avoiding a prolonged recession in the United States, activating measures enacted at the time of the Great Depression in the 1930’s and cutting base rates aggressively, to just 2.25% from a peak of 5.25% as recently as last autumn, there comes a point at which monetary policy makers have to step back and see what the impact of their actions is.

Admittedly, we are pretty convinced that the Fed doesn’t think that it can afford that luxury just yet. On the same day that observers get to see the first estimate of US economic output growth, the Fed’s Open Markets Committee pronounces on base rates at the end of its two-day meeting. According to consensus estimates the financial markets think that sufficient scope exists from the data released so far for a further 0.25% point reduction in the Funds rate, to just 2.0%!

On the basis that it can take between six and twelve months for a base rate reduction to feed its way into the real economy we might expect the first positive manifestations of last September’s initial cut to at least provide partial support in tandem with a swathe of tax rebates to be issued over the coming few weeks.

That base rate reductions are not having the desired effect already is in large part down to the freezing up in the inter-bank market and continued high inter-bank rates. That these rates have barely moved, despite aggressive action on the part of the authorities goes a long way towards illustrating how grave the prevailing situation is and how, if conditions don’t start to improve soon, even more aggressive action might be required.

Given that Dr Bernanke has spent a life time studying how to avoid an all-out deflationary spiral, that he has written on the subject and spoken formally on the subject and is now in a position to actually do something about it, how far can we be from letting the printing presses roll?

Trade weighted dollar falls as US headline inflation spikes

This might seem an unusual position to hold with inflationary indicators flashing red and the dollar in virtual free-fall against almost every major currency except sterling, however, we continue to argue that inflation is a lagging indicator and that recession, coupled with the rise in unproductive spare capacity that it will inevitably bring, should act as a powerful disinflationary force as the year progresses.

Again, far from bravely, we forecast headline US consumer price inflation of 3.3% over 2008 (against 2.9% in 2007), however, the impact of the above, coupled with plunging private sector payrolls (non-farm payrolls have never fallen by a monthly average of c100,000, as they did over Q1 2008 in any period other than recession), the continued slow motion train wreck in the residential property market (residential investment is currently falling at an annualised 25% rate, taking more than 1% point off overall GDP) and a sharp rise in petrol prices at the pumps are all serving to bear down on
consumer demand. For these reasons we expect to see US headline inflation fall back to c1.6% in 2009.

At this point it might be worth speculating what might happen if we were wrong and inflation did rise sharply, possibly in response to drastic action on the part of the Fed to head off a debt-deflationary spiral. Critically, Dr Bernanke and his coterie at the Federal Reserve squat toad-like on control of the supply of dollar bills. He has consistently maintained that he would do whatever it takes to maintain and preserve the US financial system. He will have seen warning lights flashing across the system ahead of the tumultuous decision to allow Bear Sterns to fall into the arms of JP
Morgan and the concurrent decision to extend the Fed’s facilities beyond the traditional banks. He will know that when crises occur the action required to head them off must be immediate and the amounts involved substantial.

A massive amount of paper would be required to reflate the US economy and in so doing the dollar would be compromised. Despite the US administration’s attempted assertions to the contrary (inevitable in an election year) we suspect that dollar weakness is absolutely part of Dr Bernanke’s agenda. Not a precipitous collapse in the currency but a gradual and steady reduction in value, manifest in both the exchange rate and the inflation rate.

With enough leverage around to sink a battleship it does make practical sense to carry out part of the deleveraging process through
the currency. The most important point is that all this will only help highly indebted households as long as interest rates stay below the rate of inflation (as Britain discovered in the 1970’s).

The bottom line is, therefore, that we expect US authorities to oblige and base rates to continue falling, possibly back to as low as 1% point, irrespective of the near-term cost in terms of inflation. In such circumstances investors are unlikely to want to hold cash, they are likely to want index-linked gilt edged and they may start adding risk to equity portfolios, with some trepidation, on the basis that radical action will, ultimately, pave the way to salvation.

Aggressive rate cuts from the Federal Reserve. How many left?

By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley

http://www.moneyweek.com/file/46098/crunch-time-for-the-us-economy.html

The country’s leaders should, however, not be lulled into a false sense of security. The International Monetary Fund (IMF) delivered a particularly hard hitting assessment of prospects and given that the economic imbalances in this country are as severe as in the United States there is no room for complacency.

We currently look for the UK economy to grow by 1.8% over 2008, marginally ahead of consensus (1.7%) and down from 3.0% in 2007. Although this would represent a slide back to sub-trend growth the greater concern surrounds the outlook for 2009 at which point the unwinding of the current account and personal indebtedness imbalances, coupled with the stretched state of government finances indicates a very real concern that growth in the future could be even weaker.

UK economy: the ongoing credit crisis

The most immediate problem surrounds the ongoing credit crisis and its adverse impact on the country’s financial institutions. Whilst politicians and banks argue regarding who might be to blame for the problems now affecting the global financial institutions, little has so far been done outside the US at present to resolve matters (although at the time of writing the Bank of England is rumoured to be planning to swap mortgage backed securities for, so far undisclosed amounts of government bonds for as long as possibly 1-3 years, along similar lines to the Fed’s Term Securities lending Facility).

The longer this dysfunctional state of affairs goes on, the greater the chances that serious damage might be done to the real economy. Given the significance of the financial sector to the UK economy’s well being, a prolonged period of dislocation could knock as much as 1.0% point off growth over the next twelve months.

Of greater concern is the adverse impact of the credit crunch on households and their spending intentions. Given that consumption accounts for around two-thirds of total activity, any adverse shocks emanating from the financial institutions are likely to have an even more significant (and lasting) impact. Here recent news has been far from encouraging with difficulties showing up, in particular, in the mortgage market.

The link between the mortgage market and consumption

Unsurprisingly, mortgage demand has fallen sharply over the past three months with potential buyers facing greater constraints than at any time since the last pronounced housing market downturn back in 1990-91. At present average house prices are expected to fall by between 5-10% over the next twelve months but with fairly pronounced regional variations. The figure could yet be exacerbated by the fact that the buyer holds the whip hand and distressed sellers may yet be forced to accept lower offers, particularly where no or only small chains exist.

Although the outlook for the housing market is bleak, the link between falling house prices and falling consumer spending is not obvious. Firstly, house prices have risen a long way in a relatively short space of time and many home owners will still be sitting on substantial equity built up over the past decade.

However, consumer confidence is undoubtedly impacted by falling house prices and concomitant negative media headlines regarding most people’s single biggest investment. In that confidence can be impacted by changes in, as well as the absolute level of, house prices any negative moves are likely to have an adverse effect on potential spending intentions.

Unemployment and savings

The other factor likely to impact on spending is households’ perception of employment prospects. Falling economic activity and falling corporate profitability can become self-reinforcing. Although the validity of labour market data has been called into question, it seems likely that when faced by sharply higher input costs, companies will attempt to maintain margins by cutting back their, generally, single biggest cost, labour.

We view rising unemployment as highly likely as the slowdown gathers pace and therefore, while consumer spending has held up pretty well so far, it cannot be guaranteed to continue as the slowdown begins to bite.

Furthermore, just as in the US, the UK’s household savings ratio recently plunged to all time low levels (see chart below). The combination of falling house prices and increased uncertainty regarding the outlook for the wider economy, coupled with fears over job prospects, are almost certain to encourage consumers to save more and consume less.

UK households’ savings ratio (%)

The corporate sector is less clear-cut

Turning to the corporate sector we believe that the outlook is less clear-cut, but by no means upbeat. Responding to concerns regarding falling demand, companies are likely to cut back investing intentions with construction spending under particular pressure following falls in commercial property prices.

Until Q3 2007 UK-based companies were racking up ever higher profits and margins had reached record levels. Whilst profitability is now under clear downward pressure and analyst earnings forecasts are being revised lower as a matter of course, many companies still have the benefit of being able to draw on retained profits built up over the past decade to see them through the downturn.

From an activity perspective much hinges on the ability of the export sector to limit the extent of the downturn (it alone cannot reverse it). In this context much depends on sterling’s fortunes on the foreign exchange markets.

In that context and given that the US Federal Reserve is clearly more concerned about the growth outlook and propping up an ailing Wall St. we were surprised that the accompanying statement to the Fed’s latest base rate reduction (Fed Funds rate down to 2.25%, Discount rate down to 2.5% on 18th March) was so hawkish, much more so in fact than the late January communiqué which seemed to play down inflationary pressure.

What we also know is that there were two dissenters to the latest rate cut on the Open Markets Committee (Dallas Fed chairman Fisher and Philadelphia Fed Chairman Plosser). Both are known hawks and it could be that the statement has their finger prints on it rather than those of Fed Chairman Ben Bernanke. We will know better what Mr Bernanke himself thinks about the latest, tumultuous events in the financial markets when he addresses the Congressional Joint Economics Committee on 2nd April.

What we also know is that, despite official support for the long-term health of the US economy and the dollar (which one would expect during times of uncertainty), the latter has been falling hard on the world’s foreign exchanges for quite a while. A falling dollar, in part the consequence of US monetary policy, is helping to fuel inflation thus reducing real incomes and depressing spending. Although February’s consumer price inflation (CPI) was unchanged from January, core producer price inflation increased by 0.5% over the month, its fastest rate in 17 months, for a 2.5% year on year increase.

At the same time as the dollar falls so US Treasury bond yields collapse. On 17th March the yield on the 10-year US Treasury fell to just 3.30%, i.e. below the levels it reached in the immediate aftermath of the Fed’s emergency 0.75% point reduction in the Fed Funds rate back in late January. The yield is now back down to the levels last seen in June 2003, again immediately before a Fed rate cutting meeting.

At that point the Fed signalled that the process of monetary easing was over, triggering a marked rise in yields. On this occasion we cannot feel quite so comfortable. At the time of writing risk aversion continues to run high across financial markets. The TED spread (interest rate differential between 3 month Eurodollar and 3 month Treasury contracts) remains at an uncomfortably high 160 basis points (only just off its 163 basis point high achieved in early March) and credit default swap spreads continue to stand at an equally elevated 185 basis points. There was nothing in the accompanying statement to encourage investors to believe that the process of base rate reductions has come to and end and thus bond yields, whilst offering nothing for longer term investors, continue to reflect short-term safe haven interest.

Back in the real world falling bond yields have great significance. Through its policy actions the Fed is attempting to manage the fall-out from the credit crisis and keep the US economy on an even keel. The dollar’s weakness is a reflection of policy action and one which should, in due course, provide an excellent platform for the country’s exporters to benefit. Although the US trade deficit has been falling over the past six months, it remains stretched (at c4.9% of GDP) in the context of history. This means that the US has to continue to attract financial flows from overseas to prevent an all-out balance of payments crisis developing.

For many years the rest of the world was happy to park its resources in the US Treasury bond market but as prices have risen and the dollar has fallen so global investors have woken up to the view that they are investing in a devaluing asset. In an ideal world global investors should naturally switch their attention to US equities, however, near-term inflationary pressures (coupled with the weakening dollar) indicate that this is not yet happening.

As far as global asset allocation is concerned this looks like being the next big call. Charles Stanley’s view is that at some point over Q2 investor risk appetite is likely to return. That could mark quite a turning point for the dollar which we believe will have a markedly better H2 2008 (particularly against sterling) than it experienced in H1. By extension we expect US equities to perform disproportionately well against other global equities and would be looking to build weightings to the US on a gradual basis.