International
Merrill Lynch and Morgan Stanley expect US recession in first half of 2008; Global economy expected to remain resilient
By Finfacts Team
Dec 12, 2007, 06:02

Real gross domestic product -- the output of goods and services produced by labour and property located in the United States -- increased at an annual rate of 4.9% in the third quarter of 2007. The Morgan Stanley US economics team believes that the downturn is now underway, with growth just above 0% in the fourth quarter of 2007 - - Source: US Bureau of Economic Analysis

A new report by Merrill Lynch Global Research expects the global economy to remain resistant to a slowdown in US growth. However, Merrill Lynch economists and strategists believe that whereas 2007 was a year of continuing trends, 2008 will likely be a year of economic inflection points with the rate of GDP growth rapidly changing in many countries. Another leading US investment bank Morgan Stanley, says that the US economy will have mild recession in 2008. 

The Morgan Stanley US economics team believes that the downturn is now underway, with growth just above 0 percent in the fourth quarter before slipping into two negative quarters at the beginning of 2008.  Richard Berner and David Greenlaw expect the US recession to be mild and believe that a more aggressive policy response from the Fed in the form of another 100 basis points (1 percent) of cuts will ultimately limit the duration of the downturn (see US: Coming Recession, GEF, December 10, 2007). Nonetheless, there is no escaping the central message of the US economists: for the first time in more than a decade-and-a-half, the US economy is expected to post three consecutive quarters of growth either near zero or just below it.  Private consumption growth is expected to fall precariously near to zero in the first half of next year.

"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 by 60 bp to 100 bp over the past month, so that Libor rates in that tenor are merely 20 bp lower than where they were in the spring.  Some of that jump in Libor rates reflects the transitory impact of year-end precautionary demands for liquidity.  But we think that some also represents a more fundamental deleveraging and re-intermediation of the banking system that will last well into 2008," the Morgan Stanley economists say.

In the report "2008: The Global Macro Year Ahead," Merrill Lynch has identified the following three significant cross-regional themes for 2008:

1. Global imbalances are unwinding; therefore, export-oriented companies are likely to outperform in the US, and domestically oriented companies elsewhere.

2. There are risks and limits arising from decoupling that need to be monitored.

3. Investment in sovereign wealth funds continues to grow.

"All three calls underscore our optimism that the global economy remains resilient to US economic slowdown," said Alex Patelis, head of international economics at Merrill Lynch. The report forecasts global growth ex-US moderating to 5.6 percent next year from 6.0 percent, even as the US slows from 2.2 percent to 1.4 percent.

Global Economy to Rebalance in 2008
The rebalancing of the global economy is one of three main calls for 2008 from Merrill Lynch. Imbalances in the global economy, stemming from historic dependence on the US consumer, have peaked and will unwind throughout the coming year, conclude Merrill Lynch's economists and strategists. This "rebalances" the growth within countries.

At the heart of this rebalancing, which could last several years, is the growing power of consumers outside the US and the prospect of a consumer recession within the United States. High levels of personal debt are curtailing spending habits of US consumers, while prospects for domestic demand are strong outside the United States. Merrill Lynch believes that rebalancing will be the dominant economic theme for the next three to five years. Rebalancing implies that investors should take overweight positions on export-oriented companies in the United States and domestically-oriented companies elsewhere. Also contributing to the rebalancing is the continued weakness of the dollar. Merrill Lynch's trading conditions will favour two groups: US corporations focusing on exports, and non-US companies focusing on their domestic markets.

Risks and Limits Arising From Decoupling Need to Be Monitored
In the second call, Merrill Lynch argues that investors should monitor risks and limits rising from the continued trend of the US and world economies decoupling. While many investors are asking whether a severe US downturn could prompt a world slowdown, Merrill Lynch focuses on the exact opposite: which risks might arise from the continued boom in the rest of the world relative to the United States? The report notes that these risks include the possibility of a US dollar crisis, inflation, tightening (via higher rates, stronger currencies, capital controls or quantitative measures) or the negative side-effects of inflation. Although these issues could emerge in specific countries in 2008, Merrill Lynch does not think they will be binding for the global economy as a whole.

Investment in Sovereign Wealth Funds Continues to Grow
Finally, in the third call, Merrill Lynch believes that sovereign wealth funds, boosted by rapidly growing central bank reserves, will play an important role in boosting global liquidity. Merrill Lynch expects sovereign wealth funds to double or triple their share of riskier global assets by 2010, and grow to a potential US $8 trillion by 2011.

Recession Ahead for US Consumer
According to the Merrill Lynch report, export-led companies are the silver lining for the US economy.

"The US is on the precipice of its first consumer recession since 1991, which was the last time the market suffered from a confluence of high energy prices, weakening employment conditions, real estate deflation and tightening credit," said David Rosenberg, Merrill Lynch chief North American economist.

Merrill Lynch expects modest growth to take hold late in 2008, though the US Federal Reserve will need to cut interest rates to 2 percent by mid-2009 to sustain the recovery. Latin America faces another year of solid and less volatile growth. However, the region faces challenges from less-favourable US market conditions and from high inflation that will limit scope to stimulate growth through rate cuts.

Japan's Economic Cycle Could Bottom in Late 2008; Liquidity Abundant in Asia
Merrill Lynch expects that the Japanese economic cycle could reach a bottom in the second half of 2008, as wages begin to climb again and the Bank of Japan cuts interest rates to stimulate growth. Job losses have already resulted from lower profits at smaller companies.

Third-quarter corporate profits increased 1.9% from the same quarter a year ago. Net profits earned abroad increased 35%, while domestic profits declined 4% - - Source: US Bureau of Economic Analysis

Liquidity is abundant in the rest of Asia, but constraints on economic resources are drawing near, with upside risks to inflation, domestic asset prices, or both.

"Looking into 2008, we think the macro backdrop remains positive for Asian stocks and especially currencies — for us, a multiyear standing call," said TJ Bond, Merrill Lynch chief Asia Pacific economist.

Fundamentals to Underpin Eurozone Growth
"Growth in the Eurozone will slow but remain solid in 2008." said Klaus Bader, Merrill Lynch chief Europe economist. Merrill Lynch believes that the strong currency, high oil prices and credit turmoil will impede faster growth. However, according to the report, strong fundamentals, including an absence of imbalances, and supportive monetary and fiscal policies underpin the region's strength. U.K. growth is expected to slow significantly, while Switzerland's dependence on the financial sector counts against it.

Growth in emerging EMEA will be strong in 2008, but with large variations from country to country. Uniting the entire region is the risk of higher inflation which could prompt revaluations of certain currencies. In the Gulf, fiscal spending should surge as the region starts spending windfall proceeds from the high oil price.

Oil Price to Spike Before Falling; Dollar to Recover Against G10 Currencies
Merrill Lynch believes that oil prices could spike further before Emerging Market governments move to reduce demand or OPEC moves to increase supply. Francisco Blanch, Merrill Lynch head of Commodities Research, points out that increased production and potentially slower growth should push prices below US $70 a barrel by the final quarter of the year. Prices of precious metals should continue to rise, but the outlook for industrial metals, except nickel, is negative.

Merrill Lynch expects the dollar to fall further against the euro and yen before starting to recover against G10 currencies. More heavily managed currencies, such as those in Asia, Middle East and Russia, will continue to appreciate.

Investment Implications
Under these scenarios, Merrill Lynch believes that the macro backdrop remains positive for equities versus bonds. Merrill Lynch recommends that rising economic volatility, declining correlations and higher short rates require shifting some money from stocks to cash, purchasing protection, carefully managing risk, and ensuring a diversified portfolio.