Too hot or too cold? - The Economist

Summary:
The outlook for the economy in 2008 and beyond has changed dramatically in the last 6 months. At the start of 2008, investors assumed that interest rates would fall or at least be kept on hold, due to the lingering effects of the credit crunch. Analysts forecast 15% profits growth for European countries in 2008. Now interest rates are expected to rise, and growth forecast has been revised to 4%, and dropping. The problem is inflation and inflation expectations. The essence of the current crisis is that the global economy has received two shocks in the past 12 months: the credit crunch and higher commodity prices. Those shocks have made the outlook more uncertain. Investors fear that central banks, in their zeal to prove their anti-inflationary credentials, may inflict some severe damage on economic growth. Combination of higher interest rates and lower profit margins makes it difficult to see how stockmarkets could advance much during the rest of the year. As one analyst put it: "Recent years have seen the world get all the benefits of globalisation without the costs. Emerging markets got growth, developed countries kept the lid on inflation." (Published: 12/06/08)

Notes:

• start of 2008: most investors assumed lingering effects of credit crunch would allow interest rates to fall, or at worst be kept on hold
• but: over past week markets have priced in a number of rate rises later in the year from the Fed, ECB and BoE
• has caused turmoil in short-term government-bond markets, as yields have been forced sharply higher
• problem is inflation
• central bankers know that higher inflation expectations, once entrenched, are difficult to eliminate
• sounding as tough as they can
• lack of co-ordination between central banks
  
• 3 Jun: Bernanke tried to talk up the dollar
• a falling currency adds to inflationary pressures
• 5 Jun: Trichet gave strong hint euro-zone rates were soon to rise
• sent euro sharply higher
• 6 Jun: unexpected rise in American unemployment + $11 gain in price of oil
• combination pointing to higher inflation and slower growth
• DJ Industrial Average tumbled nearly 400 points on the day in response
  
• investors fear that central banks, in their zeal to prove their anti-inflationary credentials, may inflict some severe damage on economic growth
• house prices falling in Britain and America
• consumers struggling to cope with the impact of that on their wealth and with the effect of higher fuel and food prices on their wallets
• a rise in interest rates may push them over the edge
• balancing of inflation and growth not confined to the developed world
• China: central bank raised amount of reserves banks must hold against their loans in an effort to restrain inflation
• India: central bank raised interest rates for the first time in over a year to stem inflation
• essence of the crisis
• global economy has received two shocks in the past 12 months:
• credit crunch and higher commodity prices
• those shocks have made the outlook more uncertain
• not just for the economy but for monetary policy
• uncertainty makes investors nervous
• not least because it comes after a long period when markets seem to have underpriced risk
• Peter Oppenheimer, Goldman Sachs:
• "Recent years have seen the world get all the benefits of globalisation without the costs. Emerging markets got growth, developed countries kept the lid on inflation."
• higher commodity prices are a zero-sum game: for every winner there is a loser
• many of those losers are likely to be companies
• profit margins have been at historic highs in some big countries
• in large part because businesses have been succesful in controlling labour costs
• but: higher raw-material prices present firms with a problem:
• pass those costs on, and not only will consumer demand falter, but central banks may raise rates
• so they may have to accept lower margins instead
• start 2008: analysts were forecasting 15% profits growth for European companies in 2008
• revisions have brought that number down to 4%
• largely because of problems in the finance industry
• Goldman Sachs thinks still too optimistic
• predicting an earnings decline of 12% this year
• combination of higher interest rates and lower profit margins makes it difficult to see how stockmarkets could advance much during the rest of the year