Macquarie Research
Summary of key economic and financial market forecasts
Defining Issue:
Markets continue to adjust to the reality of rising inflation and interest rates, with risk premiums now steadily incorporating the emergence of global monetary tightening.
Global Overview:
Forecasts for 2006 are already reflecting a wide divergence of views. World growth is still expected to be strong. But the distribution may be a little different, with US growth likely to be stronger than previously expected.
Currency forecasts continue to undergo adjustments. A significant depreciation in the yen and a depreciation in the Australian dollar over the remainder of 2005 and a more modest lift in expectations for 2006 are the main features.
With firm growth, but rising inflation, there is no reason to expect the US Federal Reserve to change course on monetary policy over the medium-term. The near-term, however, is subject to enormous uncertainty. A further rate hike is expected at the remaining meeting in 2005. For the rest of the world, there is an assumption that a recovery to trend growth in Europe and rising inflation will trigger a monetary tightening in the middle of 2006.
The US:
Because the data have been affected by two hurricanes, it will be some months before the central bank or financial markets can be certain about US growth. So far, however, there is little evidence of a significant downshift in the US economy. Consumer confidence plunged and there was a sharp drop in the non-manufacturing Institute for Supply Management survey in September. But other information has been upbeat. A strong manufacturing Institute for Supply Management survey, reasonable chain store sales, only a slight drop in auto sales and an employment report that was stronger than expected is the September information available so far. Weekly releases, such as initial claims and the mortgage survey, show no underlying deterioration either. The Economic Cycle Research Institute leading indicator has softened, but the rate of decline has been tame.
On balance, expectations of slower growth in late Q3 and early Q4 seem realistic. But growth should lift later in 2005 and over the first-half of 2006. The looming boost from federal government spending will be important. In addition, business spending should continue to strengthen.
Inflation is clearly emerging as a more important issue. Some policymakers (such as the Dallas Fed President) have changed their views radically over the past few months. There is a lot of anecdotal evidence highlighting intense cost pressures that need to be passed through to end users. Unless there is clear evidence of slower demand growth, it has to be assumed that some of the recent spike in energy costs will flow through to consumer prices.
Euro Area:
Surveys suggest that the low point for the European economy was in Q2. The lift in the OECD leading indicator says the same thing. Germany, in particular, seems to be responding to the weaker Euro/low interest rate combination. Even the Italian disaster does not look as bad as it did a few months ago. While soaring energy prices, aggravated by the weaker Euro, are a risk, so far the damage has been manageable.
But the rising inflation pressure has obviously alarmed the European Central Bank. Four months ago, financial markets were anticipating rate cuts in Europe. Now the only issue is the timing of the first rate rise. Given concerns about inflation, there is a risk that the first monetary tightening is sooner rather than later.
Japan:
The domestic Japanese economy is gradually emerging from a long decade of weakness. Most recently, encouraging evidence has come from the banking system, with the first loan growth since 1998, as demand for funds is increasing in tandem with the banks’ ability to lend. Normalisation of the domestic economy and financial system also implies a normalisation of portfolio allocation and risk tolerance, part of which implies a flow out of the country into non-yen assets. This helps to explain recent yen weakness and we have adjusted our exchange rate forecast to take this into account, with consequent positive effects on overall growth.
Asia: China
Data released recently show China's current-account surplus surged to US$67.3bn (more than 8% of GDP) in the first half of 2005 from just US$7.5bn in the same period of 2004. The imbalance has remained large since, driven by a widening trade surplus.
This has given a big direct boost to the economy through net export growth, but has also had an indirect impact, boosting liquidity and thereby contributing to the pick-up in investment growth recorded in recent months. GDP growth in China has therefore remained strong, rising by 9.4% yoy in July-September, the ninth consecutive quarter in which growth has exceeded 9%.
The liquidity story means that in the short-term, the risks for the economy, property and share markets are all on the upside. It also adds domestic economic pressure to the external political tensions that were already weighing on China's exchange rate regime. As a result, we continue to expect the People's Bank of China to allow the renminbi to rise against the US dollar, to US$1:Rmb8 by the end of this year, and US$1:Rmb7.5 by the end of 2006. This appreciation will ultimately dampen China's export growth and raise imports. But it will also encourage private consumption, helping to ease China's over-investment problem.
Asia: ex China & Japan
Neither the US hurricane season nor the associated rise in global oil prices has thrown our story for the Asian economies off course. On the back of sharply higher energy prices the US Service Purchasing Managers Indexes did fall sharply last month. Importantly for Asia, however, both the US and Global Manufacturing Purchasing Managers Indexes rose strongly. It is manufacturing that matters for the Asian export cycle, and it now appears that global industrial production will grow at a pace in excess of 5% in Q3 vs 2% in Q2. Data for August and September show Asian export growth has already begun to pick-up.
This is not to say that the high oil prices do not present significant challenges for Asian policy makers. Most of Asia has experienced a rise in core inflation over the past several quarters as higher oil prices and sustained strong growth above potential GDP have fanned out to push up non-energy and non-food prices. In the face of this development, central banks in Asia are raising interest rates. But with interest rates currently being so low in the region, this rise should be viewed as a gradual withdrawal of accommodation rather than the beginning of a traditional tightening cycle. In particular, higher interest rates will not prevent export growth feeding through into stronger domestic demand growth in the coming months.
Australia:
The components that are expected to drive growth remain unchanged. Consumption and housing are expected to be weak going forward, while exports and business investment are likely to be the key drivers. The fact that energy prices have sustained their high levels has further reinforced our view that consumption growth should slow in coming quarters. We currently expect the economy to grow by 2.6% in 2005 and 3.5% in 2006.
As was the case last month, consumption growth is likely to be fairly subdued in 2005 and 2006 (we are currently forecasting around 3% growth for both years) as declines in house prices and rises in petrol prices weigh on consumers. Housing is also expected to be weak over the forecast horizon, contracting this year (-3.6%) and again very slightly in 2006 (-0.7%).
Business investment remains the mainstay of growth over the forecast horizon. The GDP data showed that business investment expanded very strongly in Q2 (around 7%), while the earlier released capital expenditure survey showed that firms have significantly revised up their investment expectations for the coming 12-18 months. Moreover, the general outlook for business investment remains positive. Many sectors, particularly mining, are operating at, or close to, full capacity, and the outlook for overseas demand, particularly for commodities, remains strong. We currently expect business investment to expand by around 12% in 2005 and by 5% in 2006.
Another source of strength for the Australian economy recently has been the labour market. This is underpinning consumption, however it is also giving rise to concern about building inflationary pressures from wages. Combined with the ongoing strength in oil prices this suggests inflation is likely to rise in the quarters ahead. With the release of its November Statement on Monetary Policy the RBA has shifted back to what we characterise as a mild tightening bias. We currently expect the RBA to increase rates by a total of 50 basis points in Q2 2006.
We now anticipate that the A$ will face ongoing downward pressure over the remainder of 2005. A further lift in the US Fed funds rate in December will serve to erode the A$’s interest rate premium, while the NZ authorities desire to ‘talk down’ the NZ$ is also having a dampening impact on support for the A$.
New Zealand:
Speculation continues to mount on the looming hard landing in NZ as momentum in the economy continues to slow. That said, GDP growth for Q2 came in above expectations at 1.1%, with growth to reach an average annual rate of 2.7% by the end of 2005 before slipping to 2.0% in 2006. Growth will be driven by business investment as private consumption slow.
Residential construction looks likely to detract from growth as the housing market slows. Net exports and the current account also look likely to continue to drag on growth.
The slow down in growth will fail to ease inflationary pressure, with the peak in the cycle due sometime in 2H 2006. Annual average inflation in 2005 is expected to reach 3.1%, breaching the upper band of the RBNZ's 1-3% target range, before hitting 3.7% in 2006
The labour market is set to remain tight, with the unemployment rate dropping to 3.7% in the March quarter.
However, we should see employment growth ease from the highs of 2004. Slowing domestic activity and a downturn in the labour intensive construction and retail industries will weigh heavily on the labour sector, yet this will be offset by falling net migration.
With the sustained tightening bias by the RBNZ and the expectation of higher inflation still to come, we expect there to be a further interest rate rise by the RBNZ. Despite the economy slowing and capacity constraints easing, we are calling a December rise in the official cash rate. Record oil prices and resilient house prices are the likely catalysts behind the Banks decision to raise rates.
As the interest rate differential contracts between NZ and the US, coupled with a forecast slowing in domestic growth and an expected weakening in NZ agricultural commodity prices, the NZ$ is forecast to come under increasing pressure, depreciating to US$0.64 by year end 2006.
