With economies weakening further near term and monetary policies on hold, will equities continue to suffer?

The outlook for equities hinges on how near we are to a trough in the economic cycle. Historical evidence suggests the best time to buy is six months before the low in global industrial output growth (table below). The previous 12 months usually sees losses, while waiting for the trough risks missing out on the upside. As explained, I think growth will start to recover by year-end, which implies equities should recover.

Assuming a later trough, how much more could they fall?

Valuations seem supportive. The world earnings yield is currently 7%, which is the highest since 1985 (first chart). However, this is misleading because earnings are above trend and are likely to fall significantly. Adjusting earnings for the cycle, the yield is about 5 ¾%, which is still well above the long-term average of 5%. The 2003 stock market bottom occurred at a yield of 6%, which would imply a further 5% fall in markets.

The dollar has been performing a bit better lately. Is this the beginning of a major turnaround?

The dollar may have bottomed but a rise in US interest rates is likely to be required for a major recovery. The dollar is certainly cheap, particularly against European currencies. And the US trade position has been improving, both in absolute terms and relative to trends elsewhere (second chart). However, the low level of US interest rates is a big obstacle to a recovery. US short rates are currently more than 2% lower than Eurozone rates, which is the mirror-image of the late 1990s, when they were over 2% higher (third chart). The dollar was then strong and only started to fall significantly after the rate gap closed. Similarly, it may take a convergence of US and Eurozone rates now before the dollar embarks on a sustained uptrend.

Markets have interpreted the Report as boosting the chances of early rate cuts. However, the key message is that the growth / inflation trade-off has deteriorated and a much deeper economic slowdown will now be required to bring inflation back to target in two years’ time.

Key points:

•    The mean inflation forecast in two years’ time based on an unchanged 5.0% Bank rate remains slightly above 2% and is essentially unchanged from the May Report.

•    The forecast based on market rates is lower than in the last Report but this mainly reflects a shift in market expectations, which are 40-50 basis points higher than in May.

•    More dovishly, the three-year-ahead projection has been reduced and is now clearly below the 2% target. However, this does not necessarily imply scope for an early reduction in rates.

•    The changes to the growth projections are more striking, with the annual change in GDP now projected to fall to zero in the second quarter of next year. The May Report showed a trough at 0.9% in the first quarter.

•    However, a V-shaped recovery is forecast in the second half of 2009 and first half of 2010 – this does not suggest a need for aggressive rate-cutting.

Mr. King was diplomatic about fiscal policy but any reduction in rates will clearly become more difficult if borrowing targets are allowed to slip further.

Will the global slowdown be reflected in lower inflation?

Headline inflation is peaking but the extent of any decline is unclear. Core rates – excluding food and energy – may continue to rise a while longer, reflecting lingering capacity pressures and the pass-through of earlier cost increases.

Why will headline inflation subside?

Mainly because of the oil effect. Oil started surging about a year ago so the annual rate of increase will start to fall sharply if prices now stabilise (first chart).

Will core inflation follow headline lower?

Core rates may continue to firm near term, particularly in emerging economies, where labour markets are tight and there is greater evidence of “second round” inflation effects. A rise in core inflation could temper relief at the fall in headline rates and block central banks from easing monetary policies.

Ultimately inflation is a monetary phenomenon – has money growth slowed in the wake of the credit crisis?

It has but not by much yet. Our global broad money measure is still rising at a 12-13% annual pace, which is above the average of recent years (second chart). This is consistent with some decline in underlying inflation in 2009-10 but possibly not by enough to satisfy central banks.

So hopes of significant monetary policy easing may be disappointed?

Policies are already quite loose. For example, G7 headline inflation is now well above a weighted average of short-term interest rates. This has disturbing echoes of the 1970s, when high inflation became entrenched (third chart). Central banks will want to restore positive real rates when credit conditions begin to normalise.

Could policies be tightened then?

US interest rates are particularly low relative to inflation and are likely to be raised if the economy recovers as I expect. However, there may be scope for modest cuts in Europe. So the most likely scenario is a convergence of rates within the G7 but with little change or even a slight rise in the average.

UK consumer price inflation climbed further to an annual 4.4% in July, well above the consensus forecast of 4.1%. While food was the largest contributor to the monthly increase, “core” inflation – excluding food, energy, alcohol and tobacco – also rose significantly, reaching an annual 1.9%.

Why does inflation keep overshooting MPC and consensus expectations?

Inflationary pressures often strengthen in the early stages of economic slowdowns, for at least four reasons. First, output is typically above its trend or potential level when the slowdown begins; a fall beneath trend is needed to stem inflation momentum. Secondly, productivity tends to slow along with output, as employers are initially reluctant to cut workforces, implying faster growth in unit labour costs. Thirdly, monetary expansion often remains strong well into an economic downswing; ample liquidity accommodates price increases and may boost inflation expectations. Fourthly, a slowing economy may be associated with a fall in the exchange rate, putting upward pressure on import prices.

All these factors have been at work recently but exchange rate weakness has played a particularly important role in pushing up core inflation and magnifying the domestic impact of rising global food and energy prices.

It is too late for the MPC to influence coming high inflation outcomes, which reflect past policy mistakes. Monetary growth has slowed to a level consistent with inflation returning to target over the medium term, while the effective exchange has stabilised since April. Barring a monetary reacceleration or renewed sterling weakness, the MPC should hold to a stable course despite the obvious damage to its credibility from the current overshoot.

The following is an edited transcript of the first part of a recent interview on the global outlook. The second and third sections of the interview, discussing inflation and markets, will be posted later this week.

How has the global economy performed so far this year?

Better than might have been expected given the credit crisis and soaring commodity prices. Globally, annual industrial output growth has fallen from 5% last year to 3% in mid-2008 (first chart). So far at least, weakness in the G7 economies has been offset by continued strength in emerging markets. Output growth in the seven largest emerging economies – the E7 – was still running at 9% in mid-2008.

What is your forecast?

I expect global industrial output growth to slow further to 1-2% over coming months as G7 numbers move into negative territory and emerging economies moderate. However, this would still represent a relatively moderate downswing by historical standards – much less severe than 2001, for example. And I think growth will start to recover in late 2008 and into early 2009.

What factors will support global activity?

The US economy is probably past its low point. Last year our probability indicator suggested an evens chance of a recession (second chart). Now it’s saying the risks have receded. The change mainly reflects the Fed’s aggressive policy easing in late 2007 and early 2008. The impact of this policy change should be feeding in by late this year.

What will drive any US recovery?

The stocks cycle – initially at least. Companies have cut stocks to very low levels (third chart), which has been a major drag on the economy. I doubt they will fall further. Even if they simply stabilise, there will be a significant positive impact on growth.

How will that affect other economies?

As US firms stop cutting stocks, import demand will rise, helping to support foreign activity. There is a significant positive correlation between global industrial output growth and the US stocks cycle (fourth chart).

Could high oil prices lead to a harder economic landing?

My forecast assumes they stabilise below the recent peak. The supply / demand balance seems to be shifting as the decline in OECD consumption accelerates. Weaker OECD demand should accommodate rising emerging world consumption, barring any supply shock.

What about emerging economies?

The indicators suggest only a modest slowdown. One reason is that external finances remain strong. Emerging countries continue to pile up foreign exchange reserves. This tends to be associated with loose domestic monetary conditions, which in turn support domestic demand (fifth chart). My forecast assumes E7 industrial output growth eases from 9% to 6-7% by early 2009.

What is the main risk to your forecast?

European weakness. Europe seems to be about a year behind the US in the cycle and is turning down even as the US finds it feet. Recession risk is rising – not just in the UK but in Euroland too. Unlike the US, there is no policy stimulus in the pipeline. Globally, the risk is that a recession in Europe outweighs improvement in the US and emerging market resilience.