Coordinated central bank actions to ease liquidity strains in money markets in our view will ultimately have significant positive implications for financial markets and the economy.  Yet financial markets have yawned at the moves.  If we’re right, despite near-term risks, opportunities are emerging in US equity and credit markets.

Liquidity pressures emerged here and in Europe from two sources.  One is the overhang of uncertainty about the value of collateral and the economic outlook.  A second is the reintermediation of the banking system, which still has further to go.  Banks and securities firms have become risk averse, hoarding cash and demanding a premium to lend in the interbank market.  At the beginning of this week, that premium was running about 100 bp.

Credit worries, in time-honored fashion, are nurturing a second premium in lending markets.  Spreads over interbank lending rates have also widened significantly.  Leveraged loan rates are now higher than in June despite 100 bp of Fed ease and a similar decline in Treasury yields.   The result is a one-two punch for the economy in the form of tighter financial conditions.  The potential interplay between them, moreover, risks a self-reinforcing reduction in credit availability and a hike in the price.

Central bank policy actions — described briefly below — are aimed at increasing liquidity, helping market functioning, and avoiding that downward spiral.  Still, skeptics argue that such actions do not solve the credit problems, balance sheet constraints, and the corresponding need for capital that institutions both here and in Europe face.  That’s true, but it misses the point. 

In our view, the policy actions will eventually hit the target.  Just the promise to resolve liquidity strains has already begun to ease them; 3-month Libor-OIS spreads have narrowed 13 bp to 87 bp in the past two days.  Euribor rates have stabilized and sterling Libor rates have dipped 10 bp.  At the margin, these actions should satisfy the precautionary demands for cash and slowly bring down the risk premiums that threaten economic growth.   The Jan 08 eurodollar futures closes suggest that 3-month Libor will decline   to 4.71% by mid-January after end-of-year pressures pass.  This outcome would still leave it far above the 4% funds target the market fully expects to be in place at the end of January.  And challenges abound; the Fed’s direct auction of liquidity in the week ahead will be the next test.  For a more thorough discussion of our views, please see our full note, “Bold Action: Central Banks Likely to Succeed,” December 14, 2007.

Strategically, three points are critical:

First, these central bank moves won't change the direction of the credit cycle or the real economy; they will only help to avoid worse outcomes.  Thus, we still think the US is headed for a mild recession and that much slower growth is likely in the industrial world.

Second, the reason our credit team is a bit more optimistic on investment-grade credit is not due to changed fundamentals; rather it is because there is a lot of bad news in the price.

In contrast, equities have yet to fully discount the bad news that we expect, and we are far more cautious as a group on that asset class.

For example, George Goncalves and Lawrence Mutkin, global interest rate strategists, believe that the TAF auctions will establish the funding price for risky assets.  It would not be surprising if the TAF auction clearing yield comes above the discount rate or closer to the 1-month USD LIBOR at 5.03%.  Financial markets would find this dispiriting.  This would presumably place a short-term floor on the LIBOR-OIS spreads and therefore also on swap spreads.  But Neil McLeish, Europe credit strategist, takes comfort from the bearish consensus, and is cautiously optimistic: He remains of the opinion that credit spreads can continue to squeeze somewhat tighter into the early part of next year (as they have already been doing somewhat stealthily but meaningfully over the last few weeks).

Ted Wieseman, US fixed income economist, argues that unless these measures work quickly, the Fed will be forced to ease more aggressively (see “Fed Policy -- Lower Fed Funds Rate Not Resulting in any Real Easing, so More Aggressive Action to Come?”).  David Miles, UK economist, sees a sea change on Threadneedle Street: The magnitude is arguably less important than the symbolism of joint action and what it says about a change of heart at the Bank of England.  One assumes they will be willing to do more (in terms of quantities) if this has only limited impact.

Gerard Minack, Australia economist, notes that funding pressures are intensifying Down Under as year-end approaches.  Europe equity strategist Teun Draaisma remains cautious on European equities.  US equity strategist Abhijit Chakrabortti emphasizes that he is not bullish on equities, but more positive in the US than elsewhere, entirely because there is more bad news in the price in the US. 

Central banks’ dilemma: ‘stag’ versus ‘flation.’  I continue to expect the global macro environment in 2008 to be characterized by an unpleasant mix of relative economic stagnation in the developed countries and continuing global inflation pressures (see The Stagflation Threat, 9 November 2007).  This stagflationary environment creates a dilemma for central banks.  If they play tough on inflation, stagnation may turn into a full-blown recession.  If they decide to stimulate the economy, inflationary pressures may intensify.  Central bankers are acutely aware of this dilemma, which explains why many have been reluctant to ease monetary policy so far.  However, more signs of economic slowdown or even recession in early 2008 are likely to swing the balance towards more aggressive monetary easing in the advanced economies.  Thus, I expect 2008 to mark the beginning of another global liquidity cycle that is likely to lift most boats again in the following years.   

Current problems have monetary roots.  Today’s problems can be traced back to overly expansionary monetary policies in the first half of this decade, when the Fed, the ECB and the Bank of Japan kept rates at unusually low levels for extended periods of time. Zero or negative real short-term interest rates, combined with very low long-term interest rates, encouraged excessive risk-taking and myopic behaviour amongst lenders and borrowers, and thus helped pump up the credit bubble that is now bursting. And just as easy credit supported consumer and capital spending then, tight credit conditions will now dampen domestic demand in the US and Europe.  Moreover, easy money in the first half of this decade, with a long time lag, created the global inflationary pressures that are now playing out and are likely to persist, especially as monetary conditions in many emerging economies are still expansionary. 

Into the ‘stag.’  Economic growth in the advanced economies is likely to slow sharply in 2008.  Our US economists even expect two quarters of negative GDP growth in the first half of 2008, followed by a sub-par recovery in the second half (please see Recession Coming, by Dick Berner and David Greenlaw, in this issue).  Similarly, our Japan economists expect a mild recession and have slashed their full-year 2008 GDP forecast to only 0.9%. Our European and UK economists look for sub-par growth in the next several quarters, too, with full-year 2008 growth at 1.6% in the euro area and 1.8% in the UK and thus significantly lower than in the last couple of years.  For more colour and detail, see their articles in this issue.  Emerging economies, where growth is still strong, are likely to be affected by the slowdown in the advanced economies but have significant room for monetary and fiscal stimulus and are less exposed to the credit crunch in the developed world, which should make any slowdown much less severe. 

A new inflation regime.  The much more controversial part of my stagflation call is the ‘flation’ part.  Typically, a slowdown of growth that creates additional slack in the economy should be disinflationary.  However, there are two important caveats.  First, empirically, the link between ‘slack’ — measured by the output gap or the deviation of unemployment from its natural rate — is fairly weak.  For example, estimates by my colleague Manoj Pradhan suggest that over the past two decades, a one percentage point increase in the output gap has reduced inflation by only one-tenth of a percentage point.  Second, global factors have become more important in explaining the ups and downs of national inflation rates, especially over the last 10 years, when globalization accelerated.  Globalization was disinflationary for many years.  More recently, however, globalization has turned into an inflationary force, due to expansionary monetary policies in the emerging world, which have fuelled strong overall demand growth and, specifically, demand for energy and food.  Rising energy and food prices have also pushed total inflation higher in the advanced economies, which has started to translate into higher inflation expectations.  As I see it, the ‘low’ inflation regime of the past decade is now giving way to a ‘medium-size’ inflation regime in the advanced economies more akin to the one prevailing in the early to mid-nineties.  Cyclical factors, such as a sharp economic slowdown, may still temporarily dampen inflation, but the underlying inflation trend should be higher.  In theory, of course, central banks have the wherewithal to keep inflation low.  However, it would require much higher real interest rates than in the past ‘low’ inflation regime.  In an environment of weak growth as we envisage it in 2008, I strongly doubt central banks would tighten the screws.

The Great Monetary Easing of 2008.  Right now, most central banks in the advanced economies are still reluctant to ease, given still-strong growth and rising inflation pressures.  Only the Fed, the Bank of England and the Bank of Canada have cut rates so far.  But with weaker growth or even a mild recession ahead, I expect more central banks to reverse course and join these three in cutting official rates in 2008.  Lower rates in the advanced economies will also ease monetary conditions in those emerging economies that have their currencies tied to the dollar or the euro.  With monetary easing spilling over from the advanced economies to the emerging world, and a further rise in inflationary pressures.  In the meantime, buckle up for a stagflationary 2008.

Investors have been fretting about a US recession for months, but I don't think it's priced into markets. We may soon find out. Here's what I see as the implications of a US recession:

First, the Fed always cuts aggressively in a recession. The real Fed funds rate over the past 50 years has fallen to zero or below in every recession. That suggests to me that the minimum target for the funds rate in this cycle is 3%.

Second, market forecasts for Fed policy are usually wrong, and the error tends to be larger in an easing cycle than in a tightening cycle. I think that short-end futures are again being too conservative.

Third, long-end Treasury yields usually fall in recession - although the impact isn't as dramatic as for short rates. Moreover, real long-end yields are already at low levels, suggesting that long-end Treasuries are priced for sharply slower growth, if not outright recession. My own hunch is that in this cycle long-end yields have further to fall, driven not only by the usual cyclical forces (lower short rates, lower inflation expectations) but also by a larger-than-usual safe-haven bid as large parts of the non-Treasury debt universe are de-rated (relative to Treasuries).

Fourth, as short rates respond more aggressively than long rates to recession, it's usual for the yield curve to steepen. This cycle should be no different. The yield curve (e.g., the spread between 10- and 2-year Treasury yields) follows the Fed.  The curve always steepens when the Fed cuts. If the real funds rate falls to zero, then the 10-2 year spread should widen to around 200 basis points. Our rate strategists see the story the same way - indeed, they are forecasting steepening curves around the world. (See Jim Caron, “2008 Global Interest Rate Outlook: Year Without a Consensus,” 4 December.)

The fifth lesson from past recessions: Earnings always get hit. As Morgan Stanley US strategist Abhijit Chakrabortti notes, the median peak-to-trough decline in S&P 500 earnings in recession over the past 50 years has been 16% (see “Atonement - Navigating a US Recession,” 10 December).

Over the long term, real S&P 500 earnings have fallen to below-trend levels in every recession in the past 50 years, except the brief 1980 downturn (but then they got clobbered in 1982). Earnings are now 62% above trend. If history repeats - and I see no reason why it shouldn't -there is a huge earnings shock coming. To get real earnings to (the rising) trend by end-2008 would require a 38% decline.

Sixth, the consensus never forecasts a decline in earnings - at least not in the 22 years for which we have IBES data. There is certainly no sense of looming weakness in current forecasts. The point, however, is that consensus forecasts should never be taken as a leading indicator of the economic outlook or, indeed, earnings.

The final lesson is that as often as not, the US$ rallies in recessions. Stephen Jen, our global head of FX, thinks this pattern will be repeated, and I agree (see “The Dollar Smiles in a Recession,” 10 December).

Don’t Be Fooled – Term Premiums Are Higher

The term premium on Treasury bonds and Bunds had reached what I thought were unsustainably low levels at the end of last year (see The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma, December 19, 2006). In line with the thesis of the argument, bond yields and term premiums moved up — that is, until the onset of the sub-prime crisis. Since July, the entrenched problems in the money market, slowing growth and a considerable flight-to-safety bid have pushed Treasury yields below bond yields in the relatively unscathed euro area. Term premium estimates in the US reflect this move, but only because the models that generate these estimates are not equipped to account for the flight-to-safety bid. Controlling for such price action, the term premium is probably higher, reflecting the increased uncertainty in growth, as well as conditions that foster growth.

Some additional evidence for the subservience of the term premium estimate to the flight-to-safety bid comes from the implied volatility on US Treasuries. The MOVE index of implied volatility generally shares broad trends with the term premium.   We think Treasuries were immune to the general malaise of higher required returns, spreads and volatility because of their unique status as default-free and highly liquid securities.

There Is a Sizeable Risk Premium in the Front End Also

One condition necessary for stable growth is access to financial markets. Part of the securitisation process and some parts of the money market are still effectively shut. In such markets, funding just isn’t available, and the posted price is practically a red herring. In the parts that still have activity, prices have fluctuated dramatically, posting moves in a day that would usually take weeks. It would be tempting to compare the widening of LIBOR rates to a hike in policy rates, but that understates the severity of the tightening. While policy hikes are stable and usually telegraphed to the market in advance, the spikes in LIBOR have been very unstable. Just as Breakeven Inflation provides compensation for inflation volatility, investors look at the variability of LIBOR rates and are daunted by more than the level of the rates suggests. In other words, there is a significant uncertainty premium in the front end of money market rates that exacerbates the problem.

The Fed Will Need to Work Harder

The Fed thus needs to contend with a risk premium at both ends of the yield curve. In my opinion, this will mean that it will need to be a bit more aggressive than its hawkish statements have recently suggested. It has tried to fashion its term lending operations into a distinct instrument to deal with money market dislocations, keeping its primary weapon for dealing with the health of the macroeconomy. The chance to keep these two problems separate may well have passed. If sub-prime losses are in line with or worse than the write-downs by financial firms, house price deflation does slow consumption down and markets remain stubbornly dysfunctional beyond the recent co-ordinated central bank action and into the new year, the economy will feel the pain. Markets will probably shrug off the shroud of uncertainty only towards the end of the Fed easing cycle (see Fed Cuts and the Resolution of Macro Uncertainty, September 5, 2007), which our US team estimates is 7-9 months away.

Real Yields for Now, Breakevens Halfway Through 2008

Our US economics team expects the US to slip into a mild recession in 2008, with a relatively quick recovery. If the Fed does work harder as per the above argument, markets will start chattering about inflation again at the turn of the policy rate cycle. For now, being long real bonds seems attractive in this scenario. The time to convert that into a long breakeven position appears to be around the middle of 2008, when our US team expects the economy to start recovering.

This has been an extraordinary year.  While we were cyclically bearish on the dollar, we grossly underestimated the magnitude of the dollar descent, particularly the move in EUR/USD from 1.36 to 1.49 in late summer.  Further, we did not foresee the severity of the dislocations in the credit and money markets, although we, along with most analysts and investors, understood that the credit markets stood out at the start of the year as being mispriced, in contrast to equities or bonds.  In short, we misjudged the intensity of the market violence. 

Our calls:   the good and the bad

Let’s first assess the quality of our calls this year:

The dollar would weaken for cyclical reasons, but an improving US C/A deficit would temper the USD’s descent.  The showdown in the US housing sector would be only a source of irritation.  In other words, we were looking for a mid-cycle soft landing in the US, not a cycle-terminating shock.  Our “Dollar Smile” framework suggested the dollar would be in a vulnerable position, ironically because a slowdown in the US would not be severe. 

AXJ and other EM currencies would appreciate.  Less “pushed” than “pulled,” the world’s capital would be attracted by opportunities in the emerging market (EM) space and the dollar should weaken against the AXJ currencies. 

Risky assets (global equities) would perform well, rising enthusiastically and falling grudgingly.  Bonds and equities were out of synch and a P/E expansion would make sense.  A general shortage of tradable assets would provide persistent support for risky assets. 

The global economy would be extremely buoyant.  The effective halving of the global capital-to-labour (K/L) ratio meant that the world would/should embark on a wholesale expansion of capital expenditures, to renormalise the ratio between the world’s capital stock and effective labour supply. 

Carry trades would remain important.  Specifically, cash yield differentials would dictate the trends in exchange rates. 

Sovereign wealth funds would be the most important new category of investors in recent times.  We began highlighting the prospective emergence of SWFs in September 2006, and kept writing about their importance to risky assets, the general asset management business, financial protectionism, and other issues.  We highlighted the importance of China’s and Russia’s SWFs, and argued that Japan should have its own SWF.  We argued that these SWFs would probably favour financials, resources, high-tech, and infrastructure. 

Accelerated decline in the ‘home bias’ of Asia and EM in general.  JPY would continue to experience headwinds because Japan’s home bias was still too high and secular divestment by Japanese retail investors from JPY assets would make sense.  Similarly, the private sector in China and other EM economies would likely experience a broad-based divestment from their home assets. 

In retrospect, most of the above themes and calls were correct, and many will likely carry over to drive the markets in 2008 (particularly in 2H).  However, we underestimated the power of reserve diversification, which likely occurred at a rapid pace by Middle East sovereign funds and other large reserve holders.  The rise of EM may also have led to a decline in demand for the dollar. 

Second, the loss of confidence in the dollar was swift and prevalent, which we did not anticipate.  The dollar’s hegemonic status is being challenged by the EUR, as the GCC countries contemplate de-pegging from the dollar.  Though we quickly recognised factors fuelling inflationary pressures ― the impact of high oil prices, a Fed policy increasingly inconsistent with the GCC’s objectives, and the weakening dollar ― we did not recognise this at the beginning of the year as a key pressure point.

Third, we were more bullish on risky assets and dismissive of sell-offs in equities during the February/March and July/August sell-offs.  In a way, we captured the strong recoveries in equities very well, but may have missed the first part of the correction in the JPY crosses. 

Lessons learned and thoughts for 2008

Aside from our market calls, several themes/lessons will be important for 2008:

Lesson 1.  This is more than a sub-prime crisis.  The financial crisis we face goes beyond housing and sub-prime.  In the past, the extraordinarily low volatility environment, with a healthy gap between the return on capital and the cost of capital, led to excess leverage in some sectors.  The money markets froze up, reflecting not only the sub-prime crisis, but also a general “bank run” on capital markets in developed countries. 

Lesson 2.  Central banks are potent, but the private sector is critical, too.  In our view, recent co-ordinated liquidity action by various central banks yesterday was important, and potentially positive for financial markets and the global economy.  The Fed effectively introduced a lower-cost, anonymous, variable-rate auction version of the discount window aimed at providing liquidity beyond the cash market.  To the extent that this enhances general confidence, the term interest rates in the interbank market should start to decline.   The corporate bond and money markets’ initial reaction has been remarkably muted, and the reaction of the global equity markets has been outright negative.  But it is perhaps correct to assume that, if this variable rate tender proves to be too modest, the Fed will raise the amount auctioned and/or introduce other tools to achieve its objective.  In short, the willingness of the Fed to go to the extreme should not be in question, even though its ability to close the LIBOR-OIS spread requires a change in the behaviour/psychology of the private sector. 

Lesson 3.  Extraordinary powers of globalisation.  The rise of the emerging powers has become quite clear this year.  Their ability to withstand multiple sell-offs in the global financial markets has been remarkable.  Further, this structural rise of the real economies of EM within a fundamentally asymmetric arrangement between capitalists in the West and labourers in the East is quickly evolving into a more symmetric arrangement:   EM is now a source of capital flows, not just a destination of FDI from the West.  This, in our view, is a watershed in the balance of world economic power. 

Lesson 4.  The rise of sovereign wealth funds.  SWFs have indeed turned out to be a powerful driver of risky asset prices.  At fire-sale prices, SWFs have been particularly active with financial institutions in the developed world, which they broadly consider as strategically important.   In our view, this is not a fad but the beginning of a long-term trend, as the SWF will form the most powerful new category of investors in the world, with Japan likely the next new member.

2007 has been an extraordinary year for the CAD. It has been the best-performing G10 currency versus the US dollar, gaining 15%, and has managed to reach a record level of 0.91. We have to confess that this performance was far better than we had expected early in 2007.

Expected 2007 Outlook

When we published our outlook piece last January, we expected the CAD to underperform other G10 currencies against the USD in 2007. Our rationale was as follows: Given that CAD is already overvalued by more than 5% against the USD according to our models, the scope for appreciation is already limited. Adding to this, the weak growth in 2007, the normalization of the commodity prices coming from weaker global demand and the yield differential between the US and Canada are all factors that would weigh on CAD and are likely to contribute to its weakness. However, our scenario for CAD is not for depreciation against USD. We think CAD will underperform other currencies that are likely to appreciate against USD in 2007.  We highlighted a couple of risks to the scenario: On the upside, it seems the market is overly pessimistic on the Canadian economic outlook. Any strong signal could change this point of view and support CAD in the short run, particularly given the large short position at the moment. A sharp increase in commodity prices could also provide some support to CAD. On the downside, a crash in the housing sector or a more severe slowdown in the US would lead to weaker growth and more CAD depreciation.

The Mighty CAD

Contrary to our expectations of last January, the CAD has gained about 15% against the USD, 10% against the EUR, 7% against the JPY and 3% against the GBP. USD/CAD reached a modern-time record value in November; one has to go back to the US Civil War to see USD/CAD at lower levels. According to our fair value models, USD/CAD is now roughly 20% undervalued.

The strong performance of the CAD in 2007 can be explained by two main factors. First, the Canadian economy has continuously surprised on the upside throughout the year. At the beginning of the year, growth for 2007 was expected to be 2.2%. Following three consecutive quarters of higher-than-expected growth, 2007 growth is now estimated to be 2.5%. The first half of the year was particularly strong at 3.6% on average. The very robust domestic demand fuelled by a strong labor market was the main surprise. It was also strong enough to fully compensate for the negative contribution to growth coming from net exports.

Second, commodity prices have continued their ascent. The Bank of Canada commodity price index shows that commodity prices have increased by about 20% during 2007, with the energy component increasing almost 50% due to the sharp rise in oil prices. Strong growth around the globe has been behind this increase. The commodity prices surge has generated a massive terms-of-trade shock in Canada, giving a big boost to the currency.

In addition to the previous two factors, we also need to include increased speculative flows. Stronger growth and high commodity prices cannot explain all of the sharp appreciation of the CAD over the year. This was also highlighted in comments by the Bank of Canada’s Governor David Dodge in November saying that the abnormally rapid appreciation of the currency was not entirely due to improving terms of trade. This point is also supported by the IMM data. From net short in January, investors have gradually accumulated long CAD positions. Net long CAD positions have remained elevated for most of the year and peaked at record levels in November. Since then, they have reduced gradually, as investors are beginning to be more concerned about the growth prospects of the Canadian economy.

What to Expect in 2008

The end of 2007 is likely to give a preview of what we should expect for 2008. The CAD has given back some of its strength, as investors have started to scale back their growth expectations for the US and the Canadian economies. In addition, the Bank of Canada pre-emptively cut interest rates by 25 bp in early December. The BoC’s statement makes it obvious that, despite the strong growth seen in 2007, the combined impact from the sharp CAD appreciation, tighter credit market conditions and weaker US growth outlook will likely slow the Canadian economy in 2008.

Our US economics team recently announced that it expects a recession in the US in 2008. This should have a major impact on growth in Canada. As mentioned previously, at no other time during the past decade has the Canadian economy been better placed to withstand a US recession than it is now (see “CAD: If the US Sneezes, Will Canada Catch a Cold Again?” FX Pulse, Sept 6, 2007).  However, there is always a risk that the weak growth in the US could drag the Canadian economy into a recession.  In reaction to the slowing economy, the BoC is likely to continue cutting interest rates. Weaker growth in the US and the likely spillover to the world economy will likely mean lower commodity prices going forward, which would reduce the terms-of-trade gains enjoyed by Canada over 2007.

All these will likely be negative for the CAD in 2008. We suspect that the CAD will mainly depreciate against countries that are less sensitive to the US outlook (like the Australian dollar, which is linked to the Asian economy). We also think that the CAD could depreciate against currencies such as the Swiss franc that could benefit from a safe-haven status when growth in the US slows more markedly.

Although 2007 showed some surprises, our expectation for broad CHF weakness, mainly against the EUR, turned out to be correct. EUR/CHF mostly led to effective (trade weighted basis) CHF weakness. This happened despite the risk-reduction episodes we saw in February and August, and most recently as well. Over the year, however, and somewhat surprising to us, domestic fundamentals have failed to play any significant role in driving the CHF.

CHF as a Funding Currency…
The CHF continued to operate as a funding currency throughout 2007. Indeed, we embraced the widely acknowledged idea that “carry trades” were most likely an important source of weakness for the CHF.

…But Not Only
In February, we suggested the following: First, “With the emergence of the GBP and EUR as reserve managers’ favorite currencies in recent years, both the JPY and CHF have been crowded out somewhat”. Second, and somewhat related: “There are signs that the CHF may have lost some of its shine as a safe-haven currency in recent years….The hypothesis that the rise of the EUR as a counter-weight to the dollar may have ‘crowded out’ the role of the CHF as an ‘alternative’ currency is one we find persuasive”.

CHF Driven Mainly by External Factors

The CHF behaved almost as if domestic developments were irrelevant to the currency. Despite the EUR/CHF being considerably overvalued according our Fair Value metric, we observed little role for Swiss fundamentals (this has surprised the SNB, as well). Accordingly, external developments have played a major role in driving the CHF throughout the year. However, on some occasions, the SNB played a role in managing currency market expectations through its policy stance (we note mid-June in particular where the SNB’s Roth made bullish comments that triggered a mini rally in CHF). In March, we said: “… US investors could hedge the increased risk of a consumption slowdown by buying CHF.  In the coming months, the CHF could still prove resilient against the USD, despite the interest rate differential.  As the dust settles on US growth concerns, and because it would no longer provide such a hedge, the CHF could struggle again.”

While this turned out to be correct, we failed to pin down how the resumption of US growth concerns would keep the CHF supported in Q3 as well. In October, we changed our call in light of changing financial and economic conditions (both domestically and globally). In the midst of the US economic slowdown, we suggested that loose Swiss monetary conditions and past exchange rate weakness would provide a cushion for the Swiss economy (which was still performing well). Also, the heightened financial risks surrounding the credit turmoil would add positives to the CHF. In summary, we argued: “We expect the CHF to remain supported against late cycle economies, with the benefit of closing interest rate gaps. Moreover, the tables may turn against EUR/CHF, as well. But for this to happen on a more sustained basis, we think the SNB will need to follow words with deeds in mid-December.” 

While this turned out to be correct for GBP/CHF and USD/CHF, we saw only a moderate decline in EUR/CHF. As was widely anticipated by the market, the SNB decided to maintain rates on hold recently.  (We had expected the SNB to raise rates at this meeting despite global uncertainty, mainly because of renewed acceleration in growth and inflation, but also because of the normalized Swiss money market and the opportunity to raise rates before any eventual economic slowdown, so as to benefit from a higher level of interest rate in case these needed to be lowered).  Finally, and to follow up on this call, in November we published a note suggesting to again use the slowing US consumption as a good opportunity to build short USD/CHF positions.  While this turned out to be a positive call as the CHF broke records against the USD (reaching 1.09), the last three weeks turned into broad-based USD strength, including against the CHF. This move is likely the result (at least in part) of position squaring and profit taking. Going forward, we would expect the CHF to perform again against the USD, as the “US consumption” play described above is still relevant.  We will have a full 2008 outlook for the CHF in our next FX Pulse publication.

We’re changing our calls for US growth and monetary policy.  Since the shock of tighter financial conditions surfaced in August, we’ve incrementally reduced our outlook for future growth.  But the time for incremental changes is over.  A mild recession is now likely: We expect domestic demand to contract by an average 1% annualized in each of the next three quarters, no growth in overall GDP for the year ending in the third quarter of 2008, and corporate earnings to contract by 5-10% over that longer period.  Three factors have tipped the balance to the downside: Financial conditions continue to tighten, domestic economic weakness is broadening into capital spending, and global growth — for us, long the key bulwark against a downturn — is slowing. 

The prospect of real GDP growth persistently between 0-1% changes the character of and risks to the outlook.  Thus, we expect the Fed to insure against worse outcomes.  That process started this week with a 25 bp reduction in the Federal funds rate, a similar cut in the discount rate, and, importantly, coordinated central bank actions aimed at easing strains in money markets.  In addition, we think officials will ease by at least another 75 bp over the next 7-9 months.  Here’s why.

First, compared even with a few weeks ago, financial conditions have tightened significantly further as the price of credit has risen and lenders have made credit less available.  Money-market rates have risen significantly, and yield spreads over those money-market rates on loans have stayed high or widened.  Three-month dollar Libor-OIS spreads have jumped over the past month; while some of that increase reflects the transitory impact of year-end precautionary demands for liquidity, some represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008.  Leveraged loan and credit default swap spreads over Libor, meanwhile, have been mixed: They have tightened appreciably over the past fortnight but have widened by 40 bp or more over the past month.  High-yield and CMBS spreads have widened even more significantly, increasing the cost of borrowing for lower-rated borrowers, including those in commercial real estate.  As a result, the absolute cost of borrowing is higher than in June. 

Credit availability, moreover, likely has dwindled beyond where the Fed’s November Senior Loan Officer survey left it.  As delinquencies and defaults soar, lenders and investors are tightening credit for commercial, credit card and auto lending, as well as for mortgage borrowers.  Delinquency rates on all 1-4-unit residential mortgages jumped to a 19-year high of 5.59% in the third quarter, and the foreclosure start rate rose to a record 1.69%.  With home prices just now falling by some measures, credit tightening, and resets looming, more foreclosures are likely.  The new plan to freeze ARM resets for five years may be a win-win for some borrowers and lenders, but our US bank analyst believes that the partial freeze will not appreciably lower the expected level of bank provisioning. In addition, it may add a risk premium to mortgage credit and further reduce its availability.  Delinquencies and net charge-offs (NCOs) for other forms of credit are still low by historical standards, but they are rising.

The second new factor is coming weakness in business capital spending.  The tightening in financial conditions likely will undermine spending to some degree, but three other factors account for most of the prospective weakness in corporate capex.  Slower top-line growth, sagging operating rates, and a downturn in corporate profits all seem likely to promote a 1.7% contraction in real business capital outlays over the four quarters of 2008.  Managers will tend to extrapolate a slowdown in business activity into dimmer expectations of future growth, lower perceived returns from investing, and a reduced need to invest.  Until the economy re-accelerates, therefore, capital spending probably is at risk.  Moreover, the coming earnings recession means internally generated cash flow that has helped to finance investment over the past six years is fading fast as earnings decline — just as lending markets have turned inhospitable. 

The final factor behind our change in view is that while growth abroad is still strong, slowdowns in Europe and Japan are undermining it.  Our European colleagues have cut their GDP growth forecast for the euro area by 0.4 percentage point for 2008, to 1.6%, and by 0.3 pp for 2009, to 2.2%.  On top of spillovers from the US slowdown, a strong currency, and elevated energy prices, the increased stress in money and credit markets is likely to hurt corporate spending for most of 2008.  Likewise, tighter credit conditions and falling home prices probably will undermine UK growth.  And in Japan, our team has just cut their 2008 forecast by a full point to 0.9%.  While Japan doesn’t face a full-blown credit crunch, domestic policy blunders likely will combine with the US slowdown to produce serious weakness.  Changes to regulations are hurting consumer and small-to-medium business financing; revision of the Building Standards Law has led to a sharp drop in housing starts; and fear of tax hikes has further harmed consumer sentiment.  The upshot: Global growth likely will slip from 5% in 2007 to 4.3% in 2008, and the risks lie south of that still-hearty pace.  That’s because spillovers into other parts of the world may yet undermine legitimate resilience in Asia and Latin America, with downside risks to growth in US exports.

It’s also worth noting some lesser-plumbed features of the domestic US scene.  First, even if housing demand were to stabilize, so large is the supply-demand mismatch that builders must slash single-family housing starts by 40% from current levels to eliminate the inventory of unsold homes.  The housing downturn will likely subtract 0.9% from growth in the next four quarters, and the housing recovery in 2009 will hardly merit the name.  Second, while energy prices have come down from their recent peaks and may continue to slip, the rise in energy and food quotes between June and December of 2007 likely will have drained about $45 billion, or 0.4%, from consumer discretionary income.  And our oil team expects that crude oil quotes (measured by WTI) will average about $83/bbl in 2008, or about $10 higher than this year. 

Thus, consumers still face what could be a perfect storm.  Job gains have been supportive of income growth, with monthly gains in nonfarm payrolls running an average 103,000 in the past three months.  That is hardly surprising, as the economy grew at a 4.4% annual rate in the past two quarters, and employment lags GDP.  But the number of nonfarm self-employed workers fell by a monthly average 138,000 over the same period, although that job canvass is certainly less reliable than the payroll survey.  More timely labor-market indicators such as jobless claims are weakening; the rise to 340,000 on average over the past four weeks is a two-year high.  With wages decelerating, income gains are slowing significantly.  Housing prices and stock markets are both under pressure; we expect a 10% real decline in home prices over the next year, and that has just begun.  Thus, consumers will be more cautious. 

Those negatives sound like the recipe for a serious recession, so why do we think it will be mild?  Although it is slowing, global growth is still strong, and we expect that net exports will add about ¾ percentage point to growth through the end of 2008.  In addition, we think that corporate capital and hiring discipline in this expansion mean that there are no business-investment or labor-market excesses to unwind, adding to US economic resilience.  Finally, low inflation gives officials the latitude to respond to weakness.  But while any downturn in our view will be short and mild, the range of possible outcomes is high.

The Fed, in response to this unfolding weakness, will have more work to do.  Just to keep monetary policy neutral, the Fed must ease to offset tighter financial conditions, yet we think policy ultimately will need to turn accommodative.  At a minimum, officials will want to bring the real Federal funds rate down significantly.  Inflation risks are not dead, with the dollar having weakened, import and energy prices rising, and productivity growth slowing.  But the Fed will likely judge that the downside risks to growth outweigh upside inflation risks.

A more aggressive Fed, an earnings recession, healthy growth abroad, and a scramble for liquidity all will reinforce our longstanding market calls for steeper yield curves, higher volatility, and challenges for risky assets.  While many of these themes are in the price, economic uncertainty may extend them further.  And markets are not priced for the weakness in either US capital spending or the coming deceleration in overseas growth.  As our colleagues Abhijit Chakrabortti and Stephen Jen outline in separate pieces, despite the US downturn, those factors lead to two paradoxical and out-of-consensus market conclusions: Outperformance in US stocks and a stronger US dollar. 

Since its August 7 meeting, the FOMC has cut the fed funds target by 100 bp.  Yet broad financial conditions have tightened significantly overall, and the economy has not received anything close to what might be implied by such a large rate reduction.  Indeed, 100 bp of rate cuts may not have achieved any stimulative impact at all.  If Fed policy actions fail to foster a broader easing in financial conditions as the economy slips from near stall speed in the fourth quarter into what we believe will be a mild recession in 2008, the Fed may have to take more aggressive action with further rate cuts.  In addition, policymakers may have to increasingly tap the recently announced alternative approaches to achieve the stimulus required for a faltering economy.

Broad financial conditions have deteriorated markedly, compared to the day of the August 7 FOMC meeting.  At that point, the FOMC had just concluded a meeting at which it held the funds target steady again at a moderately restrictive 5.25% in order to combat its “predominant policy concern” that “inflation will fail to moderate as expected.”  Some key indicators have been more mixed.  The S&P 500 is very close to unchanged.  Credit markets have mostly done significantly worse.  The now off-the-run series 8 5-year investment grade CDX index widened from 38 bp to close December 12 at 85 bp.  In addition, the HiVol CDX index moved from 224 bp from 173 bp (high yield has done better, with the series 8 HY CDX improving from 433 bp to 409 bp over this period).  While declining risk free rates have helped to offset spread widening, corporate borrowing costs in the bond market have not improved much.  On the positive side, the dollar has been an area where monetary policy has achieved some clear traction, with the Fed’s major currency dollar index having weakened over 4%.  Indeed, support from net exports, with help from the dollar, has been crucial to keeping the economy from having already fallen into recession.  Our FX team, however, expects this to be reversed if the US economy continues to deteriorate, with safe haven flows likely to boost the dollar in this scenario (see Stephen Jen’s article, “The Dollar Smiles in a Recession,” December 10, 2007).

The key problem, however, remains the severe squeeze on the banking system.  The direct manifestation of this is stubbornly elevated interbank lending rates that reverberate across the economy in directly higher borrowing costs.  More important, however, is what the severe dislocations in LIBOR are telling us about the severe and rising pressures on bank balance sheets and capital — with clear and potentially severe negative implications for credit availability and pricing across the economy.

Even in the aftermath of the globally coordinated announcement of efforts to fight interbank lending pressures, term LIBOR continues to show minimal improvement from the aggressive Fed easing.  After the August FOMC meeting, 3-month LIBOR was at 5.36%, a typical 11 bp spread over the funds target.  Now 100 bp of rate cuts later and even with some significant improvement following the December 12 global central bank announcements, it has only fallen 39 bp to 4.97%.  This directly and immediately short-circuits Fed attempts to stimulate a faltering economy, given LIBOR’s key role as a benchmark interest rate.  Three-month LIBOR is the reference floating rate for the swaps market, which to a significant degree has supplanted Treasuries as the key benchmark market for the entire interest rate space since the 1998 debacle.  Term LIBOR is also the reference rate across a wide range of consumer and business loans — almost all subprime, and many prime, adjustable rate mortgages, various other consumer loans, floating rate business loans, floating rate bonds, commercial paper rates, et al.  The typically stable and narrow spread of term LIBOR over the fed funds rate — a relatively unimportant rate itself — provides the most immediate and direct transmission of rate cuts into a positive impact on the broader economy, and this transmission mechanism is simply not working to any meaningful extent.

At least as important as the direct negative impact of elevated term interbank rates, in our view, is what these pressures are telling us about the intensifying pressures on the financial system and what this implies for broader credit availability and pricing for consumers and businesses.  Significant pressure on bank balance sheets from various sources started in August and has since intensified as a result of the following:  1) the severe contraction in the asset-backed CP market, which has forced banks to bring back on balance sheet off-balance-sheet vehicles; 2) the breakdown of the non-agency mortgage securitization market, which has left more mortgages on balance sheet; 3) problems in the leveraged loan market, which have made it more difficult for banks to sell leveraged loan commitments to investors; and 4) companies having trouble accessing short-term funding drawing down bank lines of credit.  In addition, we note large and ongoing hits to bank capital from major write-downs of subprime and other assets.  And the subprime meltdown is now spreading into a much broader consumer credit deterioration, prompting growing demands to boost loan loss reserves.

With significant, rising, and unpredictable demands on their capital, banks have preferred to stay liquid and are demanding a significant premium to lend term in the interbank market.  These severe ongoing pressures on the financial system are the key drivers of the extreme dislocations in term LIBOR.  They certainly show no signs of abating anytime soon, so while coordinated central bank efforts to fight upward pressure on term LIBOR are certainly welcome and probably will have some positive impact, the underlying causes will take a long time to work through; thus, term liquidity injections by monetary authorities are unlikely to provide a quick fix. 

The risk that this ongoing squeeze on the banking system could lead to a sustained period of constrained credit availability and higher credit pricing is clear.  Indeed, the ultimate severity and duration of the financial sector squeeze — and how severe a potential credit crunch develops as a result — represents the key macro question as we head into 2008.  These risks are clearly global in nature and not just confined to the US economy.  The bottom line for the Fed is that 100 bp of rate cuts have not delivered anywhere close to 100 bp of stimulus to a faltering economy.  The more targeted global measures may help the situation, but we believe underlying pressures are too substantial to be resolved soon, even by energetic and aggressive targeted efforts. 

Just a month after we proposed that the extremely low level of the Morgan Stanley Business Conditions Index could be signalling a recession, we officially declared that a mild US recession is likely with two quarters of negative GDP growth in the first half of 2008.  This month’s canvass of our analysts supports that view.  The MSBCI remained unchanged at a weak 31% in early December, while the three-month moving average fell two points to 38%.  Survey details such as the advance bookings index and pricing conditions index were virtually unchanged at low levels, while other forward-looking indicators remained weak.  The business conditions expectations index increased four points to a still-low 32%, and analysts expect hiring and capex plans to remain weak over the next three months.

Credit conditions remain a key concern.  Our credit conditions index deteriorated slightly to 28% in December, although it remained six points above the all-time low of 22% reached in September.  Beginning with the August 2007 survey, we have also been surveying analysts on how lending standards have changed for companies under their coverage over the prior month.  This month is the fourth month that roughly half of the groups which fall into the ‘borrower’ category (~80% of sample) have faced sequentially tighter lending standards.  However, only 33% of lenders have tightened standards over the last month, down from 50% in November and 75% in October.

It is clear that the current credit crunch and the uncertainty of how it will impact the broader economy is weighing on analysts’ assessments of business conditions for their industries.  48% of analysts reported that business conditions deteriorated over the past month, while a full 59% expect conditions to deteriorate over the next six months.  Given our recession call, we are not too surprised at these results. 

Earnings disconnect.  What is surprising in light of these gloomy results is that Morgan Stanley analysts are still chipper about earnings; they expect earnings to grow 13.5% in 2008 at companies under their coverage, up from 3.3% in 2007.  This is in-line with Street S&P 500 consensus earnings growth expectations of 14.0% in 2008 versus 3.7% in 2007.

What is the story behind this divergence in analysts’ top and bottom line estimates?  One possibility is that they believe that a weaker dollar will at least be a partial offset to the effects of deteriorating credit conditions.  According to survey results, the declining dollar has helped:  41% of analysts reported that the dollar has contributed 1-3 percentage points (pp) to bottom line results, up from 28% in November, while the dollar has contributed 3pp or more to the bottom line for 7% of the group.  We also ask analysts about risks to their earnings estimates.  A full 66% believe there are downside risks to their estimates, down slightly from 73% in November.  Not surprisingly, of these nearly 80% fear worse domestic results, while 11% expect both worse domestic and foreign growth, and 7% expect margin compression.  One major wildcard is that foreign growth remains strong in the midst of a US slowdown.  Of the 34% of analysts that believe there are upside risks to their estimates, only 13% believe that will come entirely from better than expected growth abroad.  53% expect better domestic and foreign growth, while 27% expect better domestic results. 

The margins outlook is even more baffling.   In November’s survey, 55% of analysts expected margins to expand in 2007 at companies under their coverage.  This month we asked analysts about their 2008 margin outlook.  Only 39% expect margins to expand, compared to consensus Street expectations of 80%.  To get to 13.5% earnings growth in 2008, then, analysts must be expecting extremely high revenue growth, which doesn’t seem likely: Fully 59% of analysts believe there are downside risks to either domestic or foreign growth or both.

Given these results, either we’re way off the mark on our recession call and growth will be stronger than we expect over the next year or analysts’ earnings estimates will have to come down.  To be sure, there may be some mitigating factors.  An aggregate earnings number could potentially mask a combination of above-consensus and below-consensus calls.  Also, our sample could be biased; it does not include 100% of our US analysts.  However, even adjusting for some of these factors, the divergence between earnings expectations and practically recession-levels of business conditions is too big to be ignored.  We will have to wait until 2008 to find out who is right.

After a remarkable string of five years of good growth, Latin America is likely to face its first serious external shock in 2008 as the US enters into a recession.  Although the prospect of weakness in the US has hung over Mexico for some time, we are concerned that the full impact of a US downturn on Latin America has been underestimated by most regional watchers.  Indeed, we are concerned that the full brunt of our US team’s call has been underestimated by our colleagues covering the emerging economies and commodities.  As the spillover becomes clearer, we expect we will adjust our Latin American forecasts further.

Mexico: The Link Cuts Both Ways

It is of little surprise that we are cautious on Mexican growth given US weakness.   We expect Mexico’s growth to slow to 2.6% in 2008 from near 3.2% in 2007.  Indeed, given Mexico’s strong links to the US economy, some might ask why we do not have even weaker Mexican growth in 2008.  

The link between Mexico and the US is more nuanced than that of a simple relationship between GDP – it is strongest in manufacturing.  Unlike the downturn in 2001 which hit US industrial activity hard, our US team expects industrial production to continue to grow moderately in 2008.  While there are some risks to the downside in our Mexican forecast – US industrial activity could suffer more if, as we expect, global demand weakens further – we suspect that most of the downside is built into our numbers.  In contrast, the rest of Latin America is at greater risk of further downward revisions as we work through the implications of a significant weakening in US consumption.

Brazil: As Good as It Gets

Perhaps nowhere is the tension in our global view for 2008 more apparent than in Brazil.  With our China economist, Qing Wang, calling for a mild slowdown in Chinese real GDP growth in 2008 to 10%, it is not hard to see why we are expecting only a modest easing in Brazil growth in 2008, to 4.3% from 4.9% this year.  Our commodities team expects the supercycle to continue as commodity producers struggle to keep pace with Chinese demand growth.   Again, we suspect that we will have to revise downward our forecasts for Brazil growth if the US economy enters the recession path as outlined by our US team and the global spillover turns out to be more significant than our global team currently expects. 

Two points are worth bearing in mind.   First, even without a recession, we are concerned that capital flows into Brazil are likely to slow from an unprecedented high of about $90 billion in 2007 to almost a third of that level in 2008.  Second, we are skeptical that the global commodity cycle will withstand a downturn in US consumption.  If US consumption takes the hit that our US team is forecasting, we expect both Chinese import demand and commodity prices to be revised downward. 

Latin America: Playing the Hand

Our global call is a mixed one.  It is the collected work of seasoned economists from around the globe.  But somehow it strikes us as odd.  Our US team is now forecasting a recession in 2008, and our European and Japanese forecasts are highlighting a slowdown.  In contrast, decoupling appears to be the watchword in most of the emerging economies and in our commodity outlook.  When faced with global uncertainty, we tend to retreat to what we feel that we do know about Latin America. 

First, the remarkable gains we have seen in Latin America in the past five years have come as the globe has experienced extraordinary above-trend growth.  And our review of Latin America growth dynamics suggests that the principal drivers of better growth in the region have been a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand, and a remarkable surge in the terms of trade.  The most dramatic case is that of Argentina:   Had external factors played out since 2003 as our model predicted, in the ensuing years GDP growth would have averaged 3.7% per annum rather than the observed 8.8% – a difference of over five percentage points.  In the case of Brazil, the gap would have been 1.6 percentage points, largely eliminating the recent growth spurt.

Second, Latin American policy makers have not done enough to ensure that the current growth boom gives way to more sustainable, long-term growth.  Long-term growth depends on boosting human capital and infrastructure, on the rule of law, and a regulatory environment that promotes competition and fosters entrepreneurial efforts.  On a host of metrics that attempt to measure progress on those fronts, Latin America has done poorly in recent years.  Not only does Latin America have the poorest institutional and regulatory environment using measures based on the World Bank’s “Doing Business” survey, but the pace of reform has also lagged.  The World Bank notes that in 2006-07 only 36% of the countries in Latin America made at least one positive reform, compared to 79% of Eastern European nations and 63% of South Asia nations. 

The Good News

Faced with a US recession, Latin America and the “decoupling” thesis are likely to tested in 2008.  But there is good news, of course, that we have been highlighting during recent years.

First, we have seen little of the excesses common in past upturns in the region.  The abundance of the past five years has not produced either the ballooning trade and current account deficits fueled by consumer spending seen in the past, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up overvalued currencies.

Second, Latin America appears to be in better shape than in the past to deal with a downturn in the global economy.  If the world slows by more than our global team expects, then so should Latin America.  But the risks that a downturn in growth leads to a major financial crisis in the region’s largest economies is lower today than in the past.  With the trio of massive reserve accumulation, current account surpluses, and better fiscal results, Latin America has its house in better order today than in decades.

Third, some countries are making progress on the reform front.  Faced with record oil prices, Mexican policymakers this year took a significant step forward in weaning public finances off the oil addiction.  The fiscal reform came after an important patch of public finances from a reform of the public workers’ pension system.  And there are increasingly encouraging signs that an important reform in Mexico’s energy sector is slated for early next year.  None of these moves immunizes Mexico from the hand it is likely to be dealt by a US recession in 2008, but all are worthy of praise.  They are steps, each incomplete, that should help improve Mexico’s long-term growth profile.

For the first time since 2001, Mexico will face a severe external shock as the US economy falls into an outright recession in 2008.  Courtesy of the housing slump and the spillovers from tighter credit conditions, the US economy is likely to remain flat through the third quarter of next year.  Given the strong links between the two economies, Mexico’s ability to insulate itself from the US business cycle is limited.

Against this difficult cyclical backdrop, however, several tailwinds are coming into play to temper the impact on Mexican growth from the coming US recession.   Among these positive factors are soaring Mexican non-US-bound exports, an ambitious public investment plan, and expanding credit.  And even as Mexico’s growth performance may once again be among the poorest in the region, Mexico’s recent success on the reform front raises the possibility of further progress in 2008, with positive implications for competitiveness and long-term growth.

The link between the Mexican and US economies is alive — and it cuts both ways.   Indeed, time after time Mexican manufacturers have followed the ups and downs of their US counterparts, usually with only brief lags.  But unlike the downturn in 2001 that was more capex led and thus hit US manufacturers hard, the coming recession will be characterized by weakness in construction and consumer outlays.  Indeed, while US industrial activity was contracting at a 6% annual clip at its trough in late 2001, our US team expects industrial production to continue growing next year at a modest 1.5% clip. 

Accordingly, we are trimming our 2008 GDP forecast to 2.6% from 3.2% previously, a mild adjustment considering the severity of the decline during the last US recession in 2001. 

While the US remains by far Mexico’s largest trading partner, Mexico’s export dynamic is less US-centric today than at any point in the recent past in terms of both market share and growth contribution, thanks to a weakened dollar and hence a more competitive peso.  While non-US bound shipments have been growing faster than exports to the US since 2004, it is remarkable how well they have held up so far this year.  After jumping 15% in 2006, exports to the US are up just 3% in the first nine months of the year; meanwhile, growth in shipments to the rest of the world has averaged 24% in 2007, unchanged from last year’s pace (see “Mexico: A Decoupling of Sorts” in WIB, October 29, 2007).  Over the same period, Mexican exports bound for Europe and Latin America — although making up only 12% of total Mexican exports — have accounted for nearly as much of the total growth in exports as those destined for the US.  Meanwhile, Mexico has been gaining market share in the US, which should help even as the growth pace of the US pie slows.   And in terms of employment, manufacturing has played only a minor role, contributing only 13% of total job growth this year, a far cry from its 30% share in the year 2000

Moreover, the oil windfall accumulating in recent months should help to boost fiscal spending — particularly by states — in the first months of 2008, even as the federal government ramps up an ambitious program of infrastructure spending.  Courtesy of additional funds from the fiscal reform approved last September, the approved amount of total investment promoted by the public sector could top $50 billion (5% of GDP) in 2008 alone.  

And mortgage and consumer credit, which combined were still on a declining path in 2000 and 2001, have shown a significant upswing in recent years thanks to improved credit affordability and significant pent-up demand, both of which suggest that Mexico’s credit expansion can carry on largely independent of the US credit cycle.  Moreover, as our homebuilding analyst Jorge Kuri argues, the turmoil in markets for asset-backed securities and a slowdown in Mexican growth and remittances are unlikely to dent Mexico’s secular homebuilding and mortgage lending stories. 

Given the still low level of financial penetration, credit alone is unlikely to prevent the Mexican economy from feeling the pinch from slower US growth; however, combined with strong non-US-bound exports and the most ambitious public investment plan in two decades, we suspect the Mexican economy could surprise in its relative resilience next year.  Indeed, whereas we suspect that most of the downside is built into our Mexican forecast, the rest of the region seems at greater risk of further downward revisions as our global team works through the implications of a downshift in US consumption.

The Ultimate Decoupling

The most important development for Mexico in the year ahead will not be its potential resilience to a US slowdown, but its progress on the reform front.  The passage of the public pensions and, more recently, the fiscal reforms point to an administration capable of breaking through the political gridlock that characterized Mexico’s past decade and raises the possibility of further reforms, with positive implications for competitiveness and long-term growth.  Not only does progress on the reform front represent a break from Mexico’s past, but it also stands in welcome contrast to most emerging markets where the abundance of recent years has produced a significant degree of complacency. 

In particular, we suspect that moves on the energy and telecom fronts could come next year.  A meaningful set of reforms designed to boost the efficiency of spending by Mexico’s public oil company, Pemex, as well as constitutional changes that would allow private investment to complement public investment in the energy sector, could detonate an outpouring of investor interest in Mexico and reverse the ongoing decline in oil output.  Moreover, moves to produce a more competitive environment in Mexico’s telecommunications space could help reduce costs, boost innovation and serve as a powerful signal of the importance of fostering a thriving entrepreneurial base in Mexico.

Our 2008 Brazil forecast is fairly benign.  The global environment will bring less abundance, and the balance of payments is the key transmission channel for Brazil.  The current account is set to fall into deficit, and capital inflows will slow.   Still, the balance of payments should remain sufficiently strong to avoid any major currency devaluation.   Inflation stays under control, monetary easing resumes, and overall real GDP growth remains robust.  The main downside risks come from a worse-than-expected turnaround in capital flows.  In all, Brazil in 2008 still looks good, although less spectacular than in 2007.  However, long-term challenges remain: Sustaining faster growth over time will require further reforms.

Decoupling or not? As the US economy slides into recession and global growth forecasts are cut back, the debate intensifies about whether emerging markets like Brazil will be able to “decouple” from the developed world’s troubles.  The decoupling debate is misplaced, in our view, at least in its binary version. “Decoupling” should not be seen as a binary yes or no proposition, but rather as a spectrum of possibilities.  As usual with these matters, in medio stat virtus: The truth is somewhere in the middle.

The balance of payments is the main channel of transmission from global turbulence into Brazil.  In our out-of-consensus view, Brazil’s trade surplus is likely to narrow much faster than the market believes.  Robust domestic demand and a strong currency should keep imports growing rapidly, while exports are set to struggle amid a less encouraging global environment.  The market consensus calls for only a modest decline in the trade surplus in 2008.  By contrast, we see the trade surplus falling by half, to about $20 billion in 2008.  Correspondingly, while the consensus view still looks for a current account surplus next year, we are confident that the current account will fall into negative terrain in 2008. 

We look for a slowdown in capital inflows into Brazil in 2008.  As the global economy decelerates, and global risk aversion re-emerges after being dormant for years, recent all-time high capital inflows seem unlikely to persist.  Net foreign direct investment should prove relatively resilient, as this type of flow tends to follow slow-moving perceptions about longer-term trends.  But we suspect that the peak in flows into IPOs in the local stock market is behind us.  Likewise, we fear that an environment of less global risk appetite might take a toll in capital inflows into the local fixed income market.  We assume that these inflows slow towards levels seen prior to the 2007 boom.  In all, capital inflows into Brazil should slow from an unprecedented high of about $90 billion in 2007 to almost a third of that level in 2008. 

Still, the balance of payments should remain robust enough to keep the BRL relatively strong next year.  Consistent with our bearish current account view, our 2008 forecast sees a modest currency weakening by next year.  That is more cautious than the market consensus view, which sees the currency at end-2008 unchanged at recent levels.  Still, given strong starting points, sufficiently robust capital inflows should keep the currency relatively strong in 2008 from a multi-year point of view.  If our numbers materialize, Brazil would still be able to accumulate foreign reserves next year, albeit at a slower pace than in 2007.  We think that the sharp devaluations we used to see in the past are unlikely to repeat. 

CPI inflation should remain below the 4.5% official target. We assume that the strong investment which has taken place over the past many quarters will mature in time to boost Brazil’s supply response to strong domestic demand.  Rising domestic output capacity, in turn, should help allay inflation concerns.  Our 2008 forecast also assumes some moderation in food price inflation, which by far was the main culprit for the increase in headline inflation in 2007.   

Monetary easing should resume in 2008.  After pausing in October 2007, the central bank is set to stay on hold for many months, given its risk-management approach and in light of its asymmetric perception of risks: It prefers to err on the side of caution.  However, if our scenario of below-target inflation materializes, the central bank should be able to eventually resume cutting rates next year. Our forecast sees a total of 50 bp rate cuts to 10.75% at end-2008.

Fiscal policy will remain pro-cyclically expansionary. Amid strong tax revenues, the authorities should be able to continue to deliver a sufficiently large primary surplus, despite the defeat on the CPMF tax renewal for 2008, and the public sector debt/GDP ratio should continue to edge down. But the long-term health of fiscal policies in Brazil remains debatable.  Pro-cyclical fiscal policies feel great as long as revenues are growing fast, but can prove regrettably painful when the cycle takes a downturn.

Domestic demand growth should remain strong, amid a combination of expansionary policies, rapid domestic credit growth, supportive labor market conditions, upbeat consumer confidence and positive business sentiment.  Strong data for 2007 Q3 suggest that real GDP growth in 2007 could turn out a bit above the 5.0% mark, higher than our official forecast for 4.9% this year. But overall real GDP growth is set to slow to 4.3% next year, as the drag from net trade intensifies.

What are the risks to our forecast?  Risks are mainly related to the international environment.  The main downside risk to our scenario would be a sharper-than-expected turnaround in capital inflows.  If the capital account really dries up, on top of what seems to us an inevitable deterioration in the current account, then the Brazilian real would suffer, even though the central bank could lean against currency weakening by selling reserves.  In turn, currency devaluation could push inflation expectations up, arguably forcing the hand of the central bank to tighten.  Monetary tightening, for its part, could take the punchbowl from the domestic demand party. To be fair, there is potential upside risk, too.  Large interest rate differentials and global weakness of the US dollar itself could support Brazil’s bilateral exch