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Weekly Focus: Whatever Happened to Risk? (by Danske Bank)
US subprime mortgage woes have long been casting a shadow over the financial markets. Until recently, however, there had not been much fallout on financial markets in general - the problem was considered as limited to the US housing market. But perceptions changed in the course of the past week as subprime fears spread to other risk assets, and the past few days have seen pretty much all risk assets feel the heat - global equity markets have fallen, high yielding and Emerging Market currencies have come under pressure and credit spreads have widened. In other words, there has been a broad-based fall in global risk willingness. There have been a couple of instances of this earlier this year, but this time it looks stronger and more broadly based - reviving memories of May-June last year. But what is the cause and when will the current bout of jitters end? There can be no doubt that risk appetite has been high in the global financial markets. So in a way a correction is natural - with the catalyst being subprime woes this time around. But how long will the correction last - this is the big question. While the global economy is generally sound, we would definitely urge caution, as it is likely that the correction may continue for some time yet (see “Fixed Income”). That said, with the global economy in a healthy state, a long-lasting general downturn in the financial markets is probably not on the cards. [B]Euroland: ECB on Hold in August [/B] The ECB rate meeting on Thursday will dominate a busy week in Euroland. However, the meeting will be in the form of a teleconference and without the usual press conference to follow. Further, given that there was not much change in the communication that followed the last Governing Council meeting, there is nothing to suggest a change in rates at the August meeting. Like consensus, we expect the ECB will keep rates unchanged at 4.0%. As there will be no press conference, there will be no chance for the Council to send new signals to the market. Instead, it may use the opportunity afforded by the publication of the monthly report on 9 August, which would give reason to read this report rather closely. Our forecast is still that the ECB will raise rates to 4.25% at the September meeting and ultimately to 4.75% after hikes in December and March. Besides the ECB meeting, Euroland business confidence figures for July will be released. The preliminary PMI estimates and ifo, both released earlier in the week, demonstrated a modest fall in business confidence. However, the figures are still at a very strong level. As regards H2, we expect the robust growth seen in Euroland to continue, which will pave the way for further monetary policy tightening from the ECB. As well as manufacturing and service PMI, the Flash CPI estimate for Euroland will draw attention. [B]Key events of the week ahead [/B] Confidence index from the Commission on Tuesday. Business confidence (PMI) expected to largely confirm the flash estimates of the past week with service PMI at 58.1 and manufacturing PMI at 54.8. The preliminary (flash) estimate on inflation in Euroland is expected to come in at 1.9% y/y. [B]UK: No Rate Hike in the Coming Week [/B] The Bank of England's Monetary Policy Committee will be meeting in the coming week, but a change in interest rates looks unlikely. The minutes from the last meeting in early July showed that three of the nine committee members did not in fact vote for the 25bp hike that took the bank rate to 5.75%. Further, economic developments in July do not suggest that the MPC should feel it necessary to increase rates again so soon after the last hike, even though the committee will have a new Inflation Report to lean on. Meanwhile, the rest of us will have to wait for the official release of the Inflation Report on August 8. The effects of the higher British interest rates have in fact become more apparent in recent weeks, with the various measures of house prices all rising less than expected, although price growth of 10% still has to be considered as very strong. Economic growth is also solid. Q2 GDP grew 0.8% q/q or 3.0% y/y. Hence it is still our view that the BoE will hike rates one last time to 6.0% in the autumn as it becomes clear that the economy is continuing to grow at a healthy pace. [B]Key events of the week ahead [/B] Bank of England is expected to keep rates unchanged at 5.75% at its monetary policy meeting. Keep an eye on mortgage approvals. They are a good indicator of the temperature of the housing market. [B]Switzerland: Continued Stable Growth - Inflation the Key Factor for SNB [/B] The coming week sees the publication of inflation figures for July. Inflation is probably the most interesting economic variable to keep an eye on at the moment. Growth indicators have been stable in positive territory for some time, and the Swiss National Bank's main argument for continuing to tighten monetary policy is that inflation will pick up in the longer term from its currently low levels. Nor does there seem to be much doubt that inflation is on the way up, given the weak CHF, high commodity prices and growing capacity pressure in the economy. The key question for the SNB, though, is how quickly this will happen and how high inflation will climb in the coming years. The financial markets currently think it likely that the SNB will depart from its gradual tightening of monetary policy and deliver either a 50bp hike at the coming meeting in September or an extra hike outside its scheduled meetings. However, we see no grounds for haste on the part of the SNB, as inflation is under control. We therefore still expect a 25bp hike at the September meeting, followed by another in December. Business as usual, then. Going back to where we started, with the coming week's inflation figures, we expect inflation to drop back from 0.6% y/y to 0.5% y/y. This would be the first time since February that growth in consumer prices has slowed. This corresponds to a fall of 0.8% m/m, which needs to be seen primarily in the light of the traditional summer sales of footwear at reduced prices. To our mind, the SNB has a relatively aggressive inflation profile for Q3. If we are right with our inflation forecast for July, inflation will need to be right up around 1.2% on average in August and September for the SNB's inflation forecast to hold. There seems to be little chance of this, and so the inflation figures for July should reassure the markets when it comes to the risk of accelerated monetary policy tightening. [B]Key events of the week ahead [/B] The week's most important data are the inflation figures for July (see above). There will also be information on industrial activity in the form of the PMI for July, which we expect to remain high at around 60, indicating a continued upswing in industrial activity. [B]USA: Housing Market Wobbles but the Rest of the Economy is Firm [/B] The week ahead will deliver a string of important activity data as appetisers ahead of the Federal Reserve meeting in two weeks. Both Chicago and ISM business confidence are due for industry. The outlook here is for the high levels to be maintained, suggesting that US industry will enjoy a robust start to Q3 and hence be supportive of growth prospects for H2. There will also be data from the labour market in the form of the ADP report and non-farm payrolls. Despite the growth slowdown in the latter half of 2006 and the start of this year, the labour market has come through more or less unscathed. Employment growth has fallen from just below 200K per month towards the end of last year to around 150K in the first half of this year, but unemployment has remained unchanged. With the jobless rate at 4.5%, the labour market remains tight in the eyes of the Fed and there is no suggestion that the coming week's data will alter this view. In general, the data in the coming week is expected to confirm that the US economy excluding the housing market is still in fine fettle. Renewed concerns about US housing, which have been heightened by further subprime woes and soft housing market data, have largely overshadowed the positive developments in the other US activity data. The stabilisation of the housing market is taking longer than expected, but the economy picked up well again in Q2 with growth of 3½% q/q ann. (estimate). Despite increasing worries in the financial markets, there are still no signs of any serious negative fallout on the rest of the market from housing. This assessment is supported by the latest Fed statement, which does, however, note that the housing market slowdown has continued longer than expected. Turning to H2 the picture looks solid, with growth close to 3% despite the still ailing housing market. One should also remember that while the housing market accounts for 30% of the total value of the economy's asset mass, it accounts for just 5% of production value (GDP) and less than 3% of employment. Hence one should be careful not to exaggerate the housing market in assessing the prospects for US growth. [B]Key events of the week ahead [/B] Monday: PCE core inflation to rise by 0.2% m/m, keeping the annual inflation rate at 1.9%. Wednesday: Manufacturing ISM to remain at 56 and hence show continued strength. Friday: Unemployment unchanged at 4.5% and number of new jobs at 115K (consensus 130K). Friday: Service ISM to fall a little to 59. This will still indicate strong expansion though. [B]Japan: LDP Government Looks Set for a Whipping at the Polls [/B] The coming week will be dominated in Japan by the elections to the upper house of parliament on Sunday, July 29. Forecasts ahead of the election suggest that the current governing coalition of LDP and New Komeito faces a whipping at the polls and that it will lose its majority in the upper house. That said, we do not expect that much fallout from the election defeat. First of all, the upper house in Japan is relatively weak. And as the governing coalition has a more than two-thirds majority in the lower house, the upper house is unable to block most of the legislation stemming from here - only changes to the constitution require a majority in the upper house too. True, Prime Minister Shinzo Abe has considerable ambitions to change the pacifist Japanese constitution in order to bolster Japan's international role and this part of his political programme is now probably out of reach, but there are no real implications for the Japanese economy. Second, the upper house cannot unseat the prime minister. Only the lower house can do this but, as mentioned, LDP has a solid majority here. Hence, PM Abe will only step down if he decides to assume responsibility for the poor election showing or if he faces internal pressure from the LDP. Sunday's result is expected to be every bit as bad for LDP as in 1998, when the prime minister at the time resigned from office the following day. Therefore it cannot be entirely ruled out that PM Abe will reach the same conclusion and step down. If this does happen there would be a period of political uncertainty until a new prime minister was appointed. This would be the most negative scenario and the Bank of Japan would likely postpone its expected interest rate hike in August until September. The biggest negative reaction would presumably be on the stock market, and this might weaken the JPY after its recent strengthening. In our view, however, it is most unlikely that Abe would step down, even in the face of a poor result. First of all, the parliamentary system will not force him to step down, and secondly there is no obvious successor within the LDP. The favourite to replace Abe would probably be the current foreign minister, Aso, whose critics would argue is simply a less capable copy of Abe. A possible outsider could be the former finance minister, Tanigaki, who is likely be the financial markets' favourite on account of his greater openness to reform and focus on the economy. [B]Key events of the week ahead [/B] All eyes will be on the upper house election in Japan on July 29, although we see little chance of the result prompting anything as dramatic as a change of prime minister. In China, the PMI index will provide the first indication of whether slightly weaker industrial growth is on the cards for H2 07. We are looking for a modest slowdown in July given the extraordinarily strong outcome in June. [B]Fixed Income: When Do Interest Rates Bottom Out? [/B] Interest rates have been trending downwards during the past two weeks. The source of this decline is related to concerns about the US subprime market. A range of US subprime mortgage bonds have been downgraded, a couple of hedge funds with exposure to US subprime mortgages have reported heavy losses, and the biggest mortgage lender in the US reported that more borrowers with good credit histories were falling behind on their loans. The latter event fuelled worries that weakness in the subprime segment of the US housing market might spread to the market as a whole. Due to a flight-to-quality effect, government bond prices gain because they serve as a `safe heaven´ in this environment. Spreads between ten-year bond yields in the US and Germany have been stable, indicating that government bonds on both sides of the Atlantic have served as a `safe heaven´ to the same extent. We maintain our central case is that we are not going to get any deep macroeconomic ramifications from the subprime issue via either a severe tightening of credit or via housing activity. Consequently, we expect bond yields to rise once the subprime-induced market jitters have burnt out. The big question is: When will it happen? With the current strong focus on US housing concerns, any shift in market psychology requires some sort of a shock or an event signalling that the US subprime problems are not spreading to the wider economy. A potential catalyst for such a change of market sentiment is the US retail sales for July, scheduled for release on August 13. Our US economist expects these data to confirm that US consumption is on track for a robust performance in Q2. Until then, yields are likely to edge lower. [B]Danske Bank[/B]