Global
Global Forecast Risks: From Inflation Upside to Growth Downside
July 25, 2008

By Richard Berner | New York

Market concerns have appropriately shifted over the past month from upside risks to global inflation to downside risks to global growth.   Make no mistake, inflation risks are still high.  Indeed, investors and policymakers should worry both about inflation upside and growth downside.  That’s because the escalation of inflation over the past 18 months, especially in emerging market (EM) economies, is a key force undermining growth through 2009.  Consequently, the focus has shifted back to the risks to growth and the hope that a weaker economy will flatten commodity prices and cap inflation. 

That shift is reflected in our revised forecasts for global growth and inflation in both 2008 and 2009.  Reflecting a slightly stronger-than-expected first half, we now expect 4.1% growth in 2008, up 0.1% from a month ago.  But a weaker second half outlook, especially for the developing economies, likely will spill into early next year, trimming 0.2% from growth in 2009 to 3.6%.  Unfortunately, we’re not sanguine that such slower growth will materially reduce inflation: In fact, our inflation prognosis is now less favorable for both years, with increases of 0.1% in 2008 to 6% and 0.2% in 2009 to 4.8% (see Global Forecast Snapshots, July 18, 2008). 

There is a causal link between the higher inflation and lower growth in our global economic prognosis.   Higher inflation erodes discretionary income and thus undermines consumer spending.  That’s especially the case in EM economies where food and energy outlays account for half or more of consumer budgets, where those prices have pushed inflation up to double-digit rates, and where the soaring cost of government energy subsidies is forcing authorities to reduce them.  Moreover, high and rising inflation typically is associated with more volatility and uncertainty, which is the enemy of investment and growth.  In addition, higher inflation has triggered tighter monetary policies and weaker risky asset prices, which will likely depress growth in the short run. 

More ominously, to the extent that EM central banks allow inflation to gain momentum, it would call into question the longer-term structural growth story that has been so beneficial to emerging markets for the past five years.   That’s not idle conjecture: Globally, we find that around 50 countries have double-digit inflation rates.  Six of the 10 most populous countries − India, Indonesia, Pakistan, Bangladesh, Nigeria, and Russia − have double-digit inflation rates.  Nearly 3 billion people, or 42% of the world’s population, are already experiencing double-digit inflation (see The Global Monetary Analyst, “The Double-Digit Inflation Club”, June 25, 2008, and “Emerging Inflation?” July 9, 2008).  With the exception of Latin America, EM central banks are more dovish than hawkish.

Forecast aggregates mask the important revisions.   These forecast revisions may seem slight, but the aggregates mask the story in two respects.  First, our revisions to growth are more pronounced in some EM economies like China where an export-led slowdown and a reduction in energy subsidies are economic headwinds.  Our ‘imported soft landing’ baseline scenario for China is intact, with 10% GDP growth likely in 2008, but we have downgraded our 2009 growth forecast to 9%, reflecting weaker external demand and domestic energy price deregulation (see China Economics: Slower Growth Paves the Way for Policy Shift, July 17, 2008). 

Second, the annual averages conceal a more cyclical profile to growth than previously, with weakness in the next few quarters followed by recovery later in 2009.   For example, the US and euro area economies likely will be flat to down in 2H08.  But we expect a moderate recovery later in 2009 as energy prices flatten or decline somewhat and financial conditions improve (see The Perfect Storm Returns, July 7, 2008, and European Economics Chartbook: Lower Growth, Higher Inflation – ECB into Action, July 11, 2008). 

Global growth has proved more resilient than expected.   In part, that has reflected the strength of EM economies, both commodity producers and consumers.  The massive transfer of income and wealth to the commodity producers doesn’t simply disappear from the economy; it is fueling a consumption and infrastructure boom in the producing countries and feeds back into consuming country economies and financial markets.  The US fiscal stimulus has also cushioned the perfect storm for US consumers.  And credit tightening takes time to bite.

Now, growth is softening around the world, reflecting higher inflation, tighter monetary policies and financial conditions, and adverse terms of trade − that is, eroding discretionary income − for commodity consumers.  This is most apparent in the US, where falling home prices and the ongoing housing downturn are reinforcing the pressure on consumers (see The American Consumer: Stronger Now, Weaker Later, June 16, 2008).  This is also becoming apparent in the UK and in some euro area economies.  Sinking home prices and declines in industrial production signal that the UK will flirt with recession in 2H08.  Meanwhile, the recent declines in industrial orders, merchandise exports and industrial production mean that even Germany is flying at stall speed (see Germany Economics: Europe’s Last Growth Engine Sputters, July 10, 2008).

The key to market developments will be the course of inflation.  Is the current episode just another inflation scare − a cyclical pick-up in inflation that could last a while − or does it mark the beginning of a more prolonged period of higher inflation?  In our view, it is the latter: Global inflation will stay higher for longer.  Among the reasons: A global boom and lax monetary policies in EM economies have raised inflation and inflation expectations, and they will be slow to reverse.  In industrial economies, commodity price hikes may spill over into ‘second-round’ effects in wages and other prices, especially in Europe.  Finally, the relationship between economic slack and inflation has loosened in many economies over the past decade, meaning that growth will have to stay weaker for longer to relieve inflation pressures (see Global Inflation, Economic Slack and Monetary Policy, June 30, 2008).  So, while its impact will vary across regions and markets, rising inflation won’t evaporate quickly, and investors should consider these developments as a regime shift (see The New Inflation Regime: Profiting From and Protecting Against Rising Inflation Risks, June 13, 2008). 

However, inflation globally may be peaking as commodity prices, especially for energy and food, soften.  The recent sharp drop in quotes for crude oil, refined products and natural gas may be temporary. However, it is consistent with the notion that the rise in energy prices will slow or flatten for now.  Dips in base metals, agricultural and livestock prices also may provide some inflation relief.  But given the factors mentioned above, the rise in inflation expectations and still-accommodative monetary policies in both the developed and EM economies probably mean that even headline inflation will come down only slowly. 

Renewed concerns about growth are shifting the perceived balance of risks for monetary policy in some economies.   But with inflation still a concern for most central banks, monetary policy will either tighten or remain on hold in most developed economies, in our view.  Many, like the ECB, will probably welcome below-trend growth to help them bring inflation down over time, but we also expect the ECB to tighten once more this year.  Many developing-economy central banks still have more work to do.  With the exception of China and Korea, our EM team expects every single central bank under its coverage to raise rates by the end of the year.

But monetary policy in many of these economies is still extremely loose, so this new restraint is unlikely to cap, let alone tame, inflation.  Global policy rates are negative, with the nominal global policy rate currently at 4.4% and global inflation in May around 5%.  In EM, Latin America is the notable exception, with a real policy rate of 3.6%.  Most economies in Asia (ex-Japan) and Emerging Europe, Middle East and North Africa (EEMEA) have negative real interest rates, suggesting that any decline in inflation will need either stronger policy action or a helping hand from commodity markets and global growth. 

Our strategy team and we think it’s time to tactically and selectively buy risky assets, especially financials (see GEMs Equity Strategy: 2H2008 – Buy Back; Raising Equities Weighting to 6% OW, July 10, 2008; Credit Basis Report: Tactical Turn, July 18, 2008; and European Strategy: Dipping a Toe Back In, July 21, 2008).  Risky asset markets have been battered by a combination of financial shocks, higher inflation, policy tightening and slower growth.  The downside risks to markets from those developments aren’t completely gone – far from it.  In particular, the combination of slowing global growth, weaker earnings and sticky inflation implies downside risks to global cyclicals.  But for selected financials, there is a lot of bad news in the price, and many institutions are aggressively cleaning up their balance sheets; this means that there are fewer shoes to drop.  Moreover, short-term sentiment indicators have also approached extremes, and short interest is very high (at unprecedented levels for some sectors). 

Differentiating among emerging markets is critical now, and inflation is the key guide.  If inflation is peaking, thanks to flattening energy and food quotes, it will ease global inflation and growth fears.  This could prove especially beneficial for EM economies, many of whom have proven most vulnerable to those developments.  But EM investors should differentiate among them by assessing the extent of the local inflation problem and the central bank’s commitment to solve it.  Regional differences in inflation likely will become clearer when headline inflation levels off or declines, because soaring food and energy quotes have pushed inflation up everywhere.  We suspect that the problems will be most severe where monetary policy has been most lax, where currencies are pegged to the dollar or still undervalued, and for commodity consumers who have subsidized energy.  Indeed, our strategists continue to avoid the ‘stagflation trio’ of Turkey, South Africa and India.  In contrast, they favor Brazil and Mexico, which have become the standard-bearers for monetary restraint.  In part, their hawkish stance is the product of experience with hyperinflation in the past, but Latin American central banks can also afford to be tough.  Many of these countries are commodity producers, and the improvement in their terms of trade has provided a boost to growth and will underpin their currencies (see “Latin America: Latin Hawks vs. Global Doves”, This Week in Latin America, July 21, 2008).

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China
Food Price Inflation Monitor − Prices Softening in July
July 25, 2008

By Qing Wang, Denise Yam & Katherine Tai | Hong Kong

Overall food prices softened in the third week of July, according to survey data released by the Ministry of Commerce (MoC). The overall average food price level, on our estimates, edged down 0.4%W in the week ended July 18.  Data for the previous week have been revised, and now show a 0.5%W drop in the average price level, versus our earlier observation of no change. In other words, food prices have generally eased by almost 1% after the uptick at the beginning of the month (0.4%W in the week ending July 4). The ease in prices in the past week was again led by vegetables (-1.5%W). While grain and cooking oil prices remained unchanged, egg (-0.3%) and meat (-0.3%) prices fell for the second straight week.

Comparing the price level in the first three weeks of July against the average level in June, overall food prices are 0.2% lower, as the further drop in vegetable prices (-1%) and easing meat prices (-0.2%) more than offset the rise in grain prices (+0.2%). Data from the Ministry of Agriculture and the NDRC also showed some easing of prices, though not as pronounced as that suggested by the MoC data.

Our Food Price Inflation Monitor (July 2, 2008) predicted the ease in June CPI inflation to 7.1%Y. Assuming no change in the food price level in July, food inflation should fall below 15%Y in July (17.4%Y in June) due to the base effect, bringing overall CPI inflation to around 6.5%, on our estimates. We reiterate our view that CPI inflation peaked in 1H08, and will likely ease into 2H08. Nevertheless, we shall make a more informed forecast of July CPI when food price data for the remainder of the month become available.

We remain comfortable with our ‘no rate hike throughout 2008’ call, as the government appears to have put much greater emphasis on the downside risks to economic growth and financial and market stability at the current juncture.

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