Philippe d'Arvisenet, 31^th  July  2006

Economic scenario 2006-2007

After the very strong growth reported in Q1 (+5.6% at an annualised rate), the US economy has entered a slowdown. All of the signals observed in recent months concur. Manufacturing ISM contracted from 57.3 in April to 54.4 in May and again to 53.8 in June, the lowest level since August 2005, confirming the conclusions of the latest Beige Book. Non-manufacturing ISM followed a similar trend, dropping from 60.1 in April to 58.3 in May and 55 in June. Despite an upward correction to 105.7 in June, from 104.7 in May, the Conference Board's household confidence index is still far below April's reading of 109.8. Household consumption has faltered, rising only 0.1% in real terms in May, undermined not only by higher energy prices, but also by a less dynamic job market and a slowdown in the property market. Job creations slowed sharply to a monthly average of 108,000 in Q2 vs 176,000 in Q1. In spite of the recent acceleration in wages (up 3.9% y/y in June), the purchasing power per capita did not increase, with inflation exceeding 4% (the surge in energy prices accounting for two points of the increase in the price index). The downturn in the housing market hits the home construction sector and will erode the home equity wealth effect (1). The downturn in the dollar, in contrast, should help boost exports. Meanwhile, the environment is still favourable for investment, with companies in good financial health at a time when the capacity utilisation rate is returning to its historical average. In any case, that seems to be the message of statistics on capital goods shipments and new orders. Despite the slowdown in consumption, GDP growth is expected to hold near last year's level of 3.5% in 2006, before dropping below its potential rate in 2007, to about 2.6%.

Core inflation accelerated to an annual rate of 3.3% over the last three months for which statistics are available. Looking beyond questions of credibility, this admittedly lagging indicator nonetheless seems to have contributed to the FOMC's decision to raise the Fed funds key target rate for the 17th consecutive time in June. The economic slowdown is expected to ease pressures and bring core inflation back within the Fed's “comfort zone” within the next few quarters. Past rate hikes still have not had their full impact on the real economy yet, and real monetary rates, calculated on the basis of core inflation, are by no means accommodating at about 3%. Against this backdrop, and with the prospects of a slowdown, fundamentals currently argue for the upward movement of interest rates to come to a halt. By early next year, we expect to see a reversal of monetary policy trends.
In the euro zone, GDP rose 0.6% q/q in Q1, after an 0.4% increase in Q4 2005. Economic indicators continue to improve. Manufacturing PMI has risen steadily in recent months to 57.7, returning to the high point observed at the peak of the previous cycle in 2000, when GDP growth reached 4%. The new orders component was 59.4 in June, clearly signalling buoyant activity during the rest of the year. The rebound was particularly strong in Germany, where manufacturing PMI rose to 59.5.

Household confidence began to pick up in June, with a reading of –9, two points higher than the historical average. Households showed a greater inclination to proceed with big-ticket purchases (-7 in June vs -12 in May). They also expressed renewed optimism towards the job market, as the indicator on unemployment expectations dropped to 13 in June from 22 in April. This optimism is also reflected in the jobs component of the composite PMI index, which rose to 55.2 in June from 53.8 in May. Furthermore, early purchasing before Germany's VAT hike is expected to stimulate demand at the end of the year.

Investment is poised to accelerate. Cyclical productivity gains combined with a tight grip on wages have strengthened corporate profitability, and the earnings margin index gained 3% in Q1. Companies have also improved their financial health, with the debt to equity ratio falling back from 200% in 2003 to 130% at the end of last year. At the same time, debt servicing dropped to 1.5 points of GDP, from 1.75. Total gross fixed capital formation (GFCF) could rise by about 3.5% this year, vs 2.6% in 2005. Given the vigorous pace of world growth and the very gradual upturn in the euro, exports are expected to accelerate rapidly this year (8.7% in volume, vs 4.9% in 2005), in which case foreign trade would make a slightly positive contribution to growth (0.3 points after a negative contribution of 0.3 in the year-earlier period).

All in all, we expect GDP to grow by 2.5% in 2006, vs 1.4% in 2005. In 2007, the lagging impact of key rate hikes, a stronger euro and the negative impact of the VAT hike in Germany are expected to trim growth below 2%.
In June, inflation reached 2.5%. Core inflation held at 1.3% in May, although it is likely to accelerate in the months ahead. A brighter economic environment makes it easier to pass on the higher cost of imported products (energy prices in particular) to end prices. Moreover, with Germany's VAT hike, core inflation is expected to rise above 2% next year. Under these conditions, we expect the ECB to raise its refinancing rate to 3% by August and to 3.50% by the end of the year before taking a pause.

In Japan, GDP growth is poised to hold above its potential rate for the third consecutive year in 2006, after reaching 2.8% last year and 2.7% in 2004. In Q1, GDP rose 0.8% q/q, buoyed by particularly strong productive investment (3.1% q/q). The Japanese economy is growing at the fastest pace in 16 years. Industrial growth remained strong in Q2 (1.2% according to METI estimates), but the Japanese cycle now seems to be approaching a peak. The OECD leading indicator signals a cyclical downturn, while manufacturing PMI has declined since February (54.3 in June). Actually, we expect trends to return to normal. The June Tankan survey shows another improvement in the corporate financial situation, investment plans are still very ambitious, the effective exchange rate of the yen is weak, and short-term rates are negative. The upsurge in household consumption (0.5% q/q in Q1) continued in April and May, stimulated by a brighter job market and higher nominal wages. Japan is experiencing virtually full employment. More companies signalled a shortage of staff (-7 in June after –5 in May), and the ratio of job offers to job seekers is 1.07, the highest level since 1992.

All in all, growth is expected to strengthen further to 3.2% in 2006, before slowing to 1.9% in 2007, notably due to a drop off in exports following the American slowdown.

Inflation reached 0.6% in May, the highest level in eight years. Both households and companies are now anticipating further price increases, which seems to signal an end to deflation. These conditions support the idea that the Bank of Japan will abandon its zero-rate policy over the summer months. The overnight rate is expected to rise to 0.25% by the end of the year and to 0.75% by year-end 2007, while real monetary rates will either be zero or slightly negative.


(1) See our Ecoweek editorial of 3 July 2006.