Soaring Commodity Prices Bring Shift in Global Demand

In Europe and the US we are currently very preoccupied with the stagflationary tendencies resulting from the continued upward spiral in commodity and energy prices.

However, there is another effect of soaring commodity prices that must not be underestimated when considering the consequences for the global economy. For countries that export commodities and energy, rising commodity and energy prices are synonymous with rising real income. What we see in the global economy is not just higher inflation, but also a marked redistribution of purchasing power as expressed by movements in the terms of trade.

The Middle East, Africa, CIS countries and Latin America have seen massive improvements in their terms of trade at the expense of the EU, the US and Asia. To some extent this is also reflected in global demand. Take Japanese exports, for example. The EU and the US together are no longer contributing to Japanese export growth (see chart). While Asia is still making a healthy contribution, the big change is that the rest of the world is carrying more and more of the load. This group consists mainly of countries which have seen improvements in their terms of trade. In January these countries accounted for almost half of Japanese export growth.

The risk to these countries is, of course, that the global growth picture will deteriorate to the extent that questions will be asked about the high level of commodity prices, but we do not expect this to be a serious threat in the coming months. Read more about our views on commodities in our new report Commodity Monthly, the first edition of which was published during the week.

Euroland: ECB Concerns Rising - Both on Inflation and Growth

As expected ECB kept rates unchanged at 4% on Thursday. ECB continues to stress the upside risks to price stability but at the same time points to downside risks to growth. The staff projections also reflected this as the inflation projection was revised markedly higher to 2.9% in 2008 and interestingly to 2.1% for 2009 - so above the inflation objective even next year. This is based on assumptions that forward rates follow market expectations in mid-February when markets were pricing 100bp of cuts over the next year. Euroland growth was revised lower to 1.7% in 2007 and 1.8% in 2008 and risks are still stressed to be on the downside. So concerns are going up regarding both inflation and growth. Trichet increasingly refers to the euro and the strong dollar policy of US indicating some anxiety over the strengthening of the euro. This is revealing its increasing growth concerns as ECB should actually welcome a stronger euro from a pure inflation point of view. ECB wants to keep flexibility due to the very high uncertainty and does not want to send clear signals in any direction. In the Q&A Trichet stressed that it will not underwrite market expectations but added that it never does. We think ECB still overestimates the growth outlook and will cut rates eventually. Our base case is that the first cut will come in June, but it will depend on how fast growth slows down and the risk is skewed to a later cut.

As mentioned the euro is getting more attention as it continues to strengthen. This seems to go hand in hand with a rise in the oil price. From an inflation point of view it is positive that the euro strengthens when oil goes higher because it dampens the oil price rise measured in euro. But from a growth point of view it means one will get hit by both factors - as exports are hurt by the stronger euro and private consumption is slowed by the negative impact on real income from inflation.

Key events of the week ahead

• German exports out Monday. We may start to see the negative impact of a stronger euro and weaker external growth
• ZEW sentiment index released Tuesday. Is already very low and should be fairly unchanged
• Euro inflation for February out Thursday. Should be 3.2% as flash estimate showed. Focus on core inflation and any signs of second-round effects here

US: Consumers Under Siege

The economic slowdown in the US is no longer merely a housing story. In recent months US consumers have been under considerable pressure and recent data suggest that consumer spending almost stalled around New Year (see Research US - Consumers under siege). Next week we will get more information on the state of the consumer as retail sales for February will be released and we expect to see a continued subdued picture as the pressures on consumers continue.

Importantly, the slowdown in consumption spending is not only driven by declining house prices. A wholerange of negative factors, including high energy and food prices, a softer labour market, declining equity prices and tighter credit conditions have caught up with consumers. Consequently, the underlying pace of consumption has probably slowed to the 1-2% range. Generally, the uncertainty is currently very high and consumers might only be one major shock away from entering a period of protracted retrenchment. However, the most likely scenario is that consumption growth will trough in Q2 and rebound in Q3 as the fiscal stimulus packagekicks in and the pressure from energy prices eases off a bit. Despite the tax boost the effect from credit tightening, slowing house prices and a softer labour market is unlikely to dissipate fast. With underlying fundamentals for spending likely to remain soft, there will be a renewed period of widespread weakness in consumer spending around New Year 2008/2009 when the tax rebates lapse.

Overall the outlook is for a bumpy pattern in consumer spending during the next 4-6 quarters. While we do not expect consumer spending to slide into a period of sustained contraction, the situation is set to remain unusually fragile for a prolonged period. US households are not likely to enter shallow waters before mid-2009. Further, the risks remain asymmetric to the downside as a more protracted slowing in the labour market, a sharp decline in asset prices or a sharper credit slowdown could generate a deeper and more sustained slowdown in consumer spending.

Key events of the week ahead

• Thursday: Retail sales ex autos are expected to rise 0.2%
• Friday: CPI is expected to rise 0.3% m/m on the headline and core CPI is expected to rise 0.2% m/m. Headline inflation will stay above 4%.
• Friday: Consumer confidence from University of Michigan probably stays at the current low level.

Asia: Muto Nominated for Governorship of Bank of Japan

As expected, the Bank of Japan (BoJ) left its key rate unchanged at the monetary policy meeting on Friday, and it did not put out any significant new signals. If everything goes to plan, it was also the last monetary policy meeting to be chaired by current governor, Toshihiko Fukui, who will formally step down on 19 March. The Japanese government has now finally nominated current deputy governor, Toshiro Muto, as his successor. However, this has been done without reaching agreement with the opposition on his candidacy, and so we cannot rule out the possibility of his appointment being blocked and the Japanese government ending up in the extraordinary situation of having to temporarily reinstate Fukui.

Japan’s Q4 GDP growth is set to be adjusted sharply downwards in the first revised estimate due out in the coming week. In concrete terms, we expect Q4 growth to be cut to 0.5% q/q from 0.9% q/q in the preliminary estimate. This sharp downward revision is because the finance ministry published very weak figures for business investment in Q4 during the week. According to these figures, business investment in machinery and equipment fell by 7.3% y/y. We have already expressed some scepticism about the very high GDP growth in the original estimate, as it is difficult to reconcile this with the clear slowdown in the Japanese labour market at the end of 2007. However, the downward revision in itself will not mean anything for monetary policy in Japan. Growth was slightly above potential growth in Q4 and will probably fall to slightly below potential growth in Q1, which means that the BoJ will stay on hold for now.

In China, the National People’s Congress is in full swing. Prime minister, Wen Jiabao, signalled in his address that fighting inflation has top priority, and that the ambitious plans to control credit growth stand. The government has announced quarterly credit quotas in a bid to bring credit growth down significantly during the course of 2008 (see chart). There had otherwise been speculation that the Chinese government would ease back slightly on its ambitions in the light of the uncertainty about the global economy and the chaos in the wake of the recent snowstorms. If the Chinese government does stick to its tough targets for credit, this could hit investment hard in the coming months.

Key events of the week ahead

• Revised Japanese GDP figures for Q4 are due on Thursday. We expect a sharp downward revision (see above).
• It will be interesting to see what happens in terms of the Japanese government’s nomination of Toshiro Muto for the BoJ governorship.
• In China, the National People’s Congress is ongoing, and a new government is expected to be appointed during the week.

Foreign Exchange: Is the Decline in USD Disorderly?

The newsflow makes for scary reading these days. The crisis in the financial markets appears to be escalating again, and the past week has witnessed falling equity prices, ditto bond yields, rising credit spreads and a general increase in risk premiums. Several markets are now in their worst position for the past year despite the not insignificant efforts of the central banks. The economic front looks none too rosy either. In the US, the benchmark ISM industry index fell below 50, and housing foreclosures rose to their highest level ever (data since 1985).

The fallout on the FX market is mostly as could have been predicted. EUR/USD has risen sharply during the week, hitting new highs above 1.54. Only two currencies have performed better than EUR, and they are CHF and NOK. The list of currencies that have performed worse is long, and topped by ZAR, TRY, KRW and ISK. Our three-month target for EUR/USD of 1.55 risks coming into play faster than we expected (see FX forecast update). Indeed the speed with which the dollar is falling at the moment suggests a certain degree of panic. Back in November we outlined the circumstances under which the decline in the dollar could become disorderly (see Will the decline in USD become disorderly?). At the time, we concluded that the outlook for the US economy, a deterioration of the financial crisis and a declining tendency to use USD as a reserve currency added up to further falls in USD. All three arguments still appear valid, which is why we still do not believe that EUR/USD has peaked. It also seems premature to believe in intervention from the G3 central banks. At the ECB, monetary policy is still directed to fighting inflationary pressures, while in the US it is attempting to stimulate the economy. So long as this situation continues, the central banks cannot sell EUR/USD. Japan, too, would find it difficult to intervene as long as JPY is generally undervalued. As before, our view is that both an economic slowdown and a financial crisis will benefit currencies such as EUR, JPY and CHF, whereas we expect that carry strategies will continue to underperform.

There will be a monetary policy meeting in Switzerland on Thursday, when we expect that the SNB will keep rates unchanged at 2.75%. In may ways the SNB finds itself in the same dilemma as the ECB, as economic growth is on the wane, while inflation is running above the official target. Compared to Euroland, however, the slowdown in growth is less pronounced, while underlying inflation is lower. For now we expect just one rate cut from the SNB this year, compared to three from the ECB. Combined with continuing financial turmoil, we expect CHF to strengthen further in the coming year to 1.54 against EUR.

Norway’s central bank will also be meeting on Thursday. We expect unchanged rates, but the rhetoric will be skewed towards an interest rate hike in May given rising inflation and solid domestic growth. The former will presumably be confirmed on Monday, with the release of consumer and producer prices for February. The fall in EUR/NOK in the past week is impressive given that risk aversion has increased generally, and we expect to see further NOK strength going forward.

Commodities: Precious Metal Passion - Could Gold Hit USD 1200?

Precious metal prices have risen sharply in the past two months. Minor metals, platinum and palladium, in particular, have soared, with palladium rising more than 55% and platinum up around 38%. Platinum is the more important of the two, and the main reason for the surge in prices is major problems at the South African mines, which account for 78% of the world’s platinum production. The problem is basically that the mines are suffering power shortages, and this is hitting operations. The state-owned electricity supplier, ESKOM, announced in the middle of February that mines and other industrial users could only have 90% of their normal electricity consumption supplied until 2012. The reason for such a drastic measure is a massive lack of investment in electricity-generating capacity over many years in an economy that has otherwise been booming. The mining companies have already announced lower production this year. Anglo Platinum, the largest South African producer, has announced that production will fall by 6% this year. Palladium, a less important metal, has also been hit by the problems in South Africa, which accounts for 39% of global production. Prices have risen on the back of expectations that palladium will increasingly act as a substitute for platinum. While the price of these two minor precious metals has rocketed in recent months, it is certainly possible that prices will increase even further if the problems in South Africa remain unresolved and investors continue to show great interest in commodities - as outlined below.

Prices on the precious metal "majors", gold and silver, have also surged this year, despite underlying physical demand being hit by the rising prices. Gold jewellery demand fell 17% in Q4 07, according to the producer organisation, the World Gold Council.

In our view, gold and silver prices have primarily been boosted by rising inflation and inflation fears, together with the weakening of the dollar. The combination of these factors in an environment where equities and credit products are under pressure, has prompted investors to take a serious look at alternatives, and gold has traditionally performed well in such situations. Gold is, in principle, the counterpart to the dollar, and is viewed as a hedge against inflation and the ultimate safe haven at a time when the US economy is close to meltdown. The US central bank signalling lower rates, apparently not focused on inflation, and explicitly warning that a number of smaller US banks risk going out of business, adds up to just about the best recommendation gold can have.

As we write in the "Foreign exchange" section of this week’s Weekly Focus, we are considering revising our FX forecast in the direction of an even weaker dollar. Meanwhile, we expect that the US Fed funds rate will fall to 2% or perhaps even lower as the US economy continues to struggle. We therefore expect that gold will break through the magical $1,000 per troy ounce mark, and that the peak may be as high as $1,200 in 2008. We also expect silver prices to rise, but not to the same extent. In a tumultuous situation such as the present, the only thing that sparkles for investors is gold.

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