Top ten threats to the global status quo in 2007

As 2006 draws to a close, Jeremy Batstone of Charles Stanley is feeling bearish on the global economy. These are the ten economic trends to watch - and how to invest accordingly.

We round off another year's worth of Week In Preview publications by unleashing our most pathologically bearish thoughts as something of an antidote to the cosy continuation of the global economic and financial market status quo which form the majority of financial commentaries and City firms' base cases at this time of year. This is not to say that we at Charles Stanley have changed our base case expectations for 2007 within the space of just a week, but simply to reiterate the fact that the professional investor adopts a different approach to making money from the financial markets than does the financial media or the interested amateur. In a nut shell the professional looks at what is being priced into markets by reference to futures market pricing now. By then overlaying one's own perception of how one feels the markets may perform a view can be taken as to whether the markets are likely to be right or wrongfollowing which one can invest accordingly.

Our base case scenario (articulated in our latest monthly Investment Handbook) indicates that while US growth will slow to below trend, activity is still forecast to emerge at or around 2.5% for 2007. Whilst the dollar may struggle to retain its poise it is not forecast to collapse, particularly against sterling as the UK economy displays many of the same structural imbalances amplified by the US economy. Globally, growth is expected to become more balanced as the eurozone and Asia successfully pick up the baton passed by slowing cyclical US activity. Most investors are comfortable with this outlook. It implies that all threats are manageable, that the remarkable acceptance of risk from financial instruments can continue and that with the inflation threat quiescent and base rates in the developed West at or close to cyclical peaks, equities can continue their merry way upward.

Those investors of a sensitive disposition should turn away now. For the rest, please read on

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

1. While we forecast the US economy to grow by 2.5% over 2007, the risk to US economic activity growth lies to the downside. The single most significant risk lies with the outlook for consumption via the wealth effect. The big gains in personal wealth during the housing boom go a long way towards explaining a savings ratio in negative territory. Now that house prices have fallen and significant quantities of unsold inventory exists, expect the savings ratio to be rebuilt. As consumption slows, expect the closely correlated business investment to fall too. Growth of c1.5% over Q4 2006 (after a slew of weak data) would represent four consecutive quarters of below-trend growth and pave the way for a March base rate cut.

2. As US growth slows and the Fed moves into easing mode investors should expect the dollar to resume its slide on the global foreign exchange markets. By way of a road map, we believe that the consistently hawkish Richmond Fed President Jeffrey Lacker's decision to return to the fold (having voted to hike US base rates at the four previous FOMC meetings) should begin a process which follows with a removal of the de facto tightening bias to policy at the 31st January FOMC meeting, thence to the bi-annual Humphrey Hawkins Testimony within which Dr Bernanke will allude to policy easing on the way in February and concluding with policy easing at the March FOMC. A failure to stick to the map would cause investors to worry about an even harder economic landing, the likelihood of even more aggressive easing in following months and a more precipitous decline in the dollar.

3. As this publication is released US Treasury Secretary Henry (Henk) Paulson and Dr Bernanke head up a weighty US delegation to China. Central to market interest is whether the diplomatically able Paulson can engineer concessions from the Chinese authorities regarding the pegged renminbi. Massive pressure on the Chinese currency and the Peoples' Bank of China has built up as a result of aggressive capital (and speculative) inflows. Whilst it is by no means in the Chinese interest to create a disorderly market by removing the peg immediately, recent dollar weakness does provide the ideal opportunity for China to allow a more aggressive currency appreciation against the dollar without seriously damaging overall competitiveness. Expect further renminbi appreciation as the peg learns to crawl better in 2007.

4. Japan is also the focus of investor attention at present. The Japanese economy is still the world's second largest, boasting a GDP still twice the size of that of China. It too has substantial foreign exchange reserves and, in the fourth year of robust economic growth and buoyant optimism amongst domestic manufacturers, much speculation surrounds the scope for aggressively higher Japanese base rates. Standing at just 0.25% the Official Discount Rate is expected to rise again, possibly as soon as next week. With the economy displaying positive momentum and inflationary pressure rising only political pressure is acting as a significant impediment to higher base rates. Given that monetary policy would still be in neutral at 2.0% the risk for 2007 is that Japanese base rates surprise on the upside. The combination of falling US base rates and rising Japanese rates has significant implications, not just for the yen (we see it hitting 95 against the dollar) but also for the carry trade and consequent financial market volatility!

5) The eurozone appears in rude health judging by backward looking activity data. A better glimpse into what the future may hold is provided by German ZEW survey data which indicates that whilst current conditions remain buoyant, the expectations index has collapsed from positive to negative territory. European consumers, businesses and politicians alike are concerned by the European Central Bank's (ECB) desire to keep raising regional base rates to squeeze inflationary pressure out of the system. To some extent the euro's strength on the foreign exchanges, coupled with a more pragmatic approach from the central bank, should help but with the M3 monetary aggregate still growing strongly our sense is that the region's "sado-monetarism" could end up causing eurozone activity to ebb. To this end the already flat bond yield curve is showing signs of inverting, a clear signal from the markets regarding the risks ahead. As activity stalls expect to hear siren voices (emanating in particular from the fragile Italian economy) regarding the future of the euro project.

6) If one believes the UK Chancellor Gordon Brown (and why not given his GDP growth record?) the UK economy appears equally robust. We and others here at Charles Stanley have already picked over the minutia of the latest Pre-Budget Report but we cannot help ourselves thinking that growth achieved over the past five years has been paid for through a sharp deterioration in the public finances and that UK growth could disappoint going forward. Yet again, the Chancellor had to revise up his forecast for public borrowing and in order to bring the public finances back onto a steady footing taxes may need to be raised (although there is no great urgency here following the earlier manipulation of the definition of the economic cycle) and government spending needs to be cut back. Official growth forecasts are above City consensus and with fiscal policy likely to be much less supportive in the future than in the past, coupled with tightening monetary policy bearing down on an already hugely indebted and tax-encumbered consumer the risk here lies to the downside too.

7. Call it shameful US ignorance, call it (as has Niall Fergusson, professor of history at Harvard University) a US attention deficit, call it rival warlords jockeying to carve our powerbases as Iraq descends into an anarchy which might, on occasions, make even Hyronomous Bosch blush, call it what you like but the civil war in Iraq seems no closer to resolution. With a hamstrung legislature in "control", domestic commitment to ongoing US involvement in Iraq is waning. A descent into the maelstrom of civil war with emasculated Western armies powerless to police a disaster in part of their own making risks drawing other Middle Eastern countries into the conflict, from maverick Iran through Syria, Saudi Arabia, Turkey to Israel. A conflagration such as that, on top of one of the world's single largest oil resources, could yet cause another spike in that commodity's price, raising the threat of recession elsewhere.

8. So which is right? Are we to believe financial market insouciance? That the ongoing crisis in the Middle East is little more than a media-inspired conspiracy to make things seem worse than they are in order to gain viewers and sell copy in an increasingly clogged market place? Or are the financial markets looking the other way incapable, as ever, adequately to price in the risk associated with low probability but highly catastrophic events? There are other reasons to fear the return of financial market volatility in 2007. Perhaps the most potentially pressing of these is the fall-out from the unwinding of the "carry trade" in which investors borrow in low interest countries such as Japan and invest the proceeds in high yielding emerging markets, the US or elsewhere. A strong suspicion exists that the May / June equity market shake out was caused, in no small measure, by the reaction to the Bank of Japan's first base rate hike. Whilst the reaction to incremental hikes is progressively less pronounced, the fairly prolonged hiatus that has evolved since the first Bank of Japan move suggests that further tightening could have just as significant an impact. With volatility, as measured by the VIX implied volatility index back close to all-time lows, little to chose between developed and emerging market debt and a surge in alternative asset class speculation, the potential consequences of a blow to the staus quo are all too evident.

9. Whilst global valuations, both absolute and relative, appear highly supportive to a continuation of the now prolonged equity bull market one of the consequences of some, or all, of the above mentioned factors might be to cause profit growth to disappoint and the absolute valuation peg to be kicked away. We see a marked divergence, regular at cyclical turning points, between "top down" pessimism and "bottom up" optimism. Strategists keep a close eye on the big picture and see darkening clouds on the horizon. Sector and stock analysts concentrate more on the outlook for their charges based largely on information derived from companies themselves. Whilst some corporations are blessed with great foresight, most are not. Able management teams are well placed to take advantage, reactively, to a whole spectrum of operating conditions and the willingness on the part of the vast majority of companies to embrace technological change and increased globalisation has helped profit margins to surge to hitherto unmatched peaks. There are plenty of reasons to suggest that these levels might be unsustainable, from unhelpful US Fed policy to higher wage claims as labour attempts to recover its lost share of profitability. The oncoming cyclical slowdown in the US will squeeze profitability anyway and PE ratios may come under further pressure as investors become increasingly risk averse.

10) A tremor of seismic proportions in the world of football as the writer's beloved Portsmouth Football Club gain a place in the Champions' League! Gone are the days of pre-season friendlies against the likes of Spanish Alaves in which the latter brought precisely no travelling support. Welcome away trips to the San Siro and Bernabau. The glory days really are back at Frogmore Rd!

By Jeremy Batstone, Director of Private Client Research at Charles Stanley