A Slowdown Is Normal 18 Months Into a Recovery

Doroth�e Enskog: The economic recovery seems to be running out of steam. Are countries such as the US and the UK facing a double-dip recession?

Giles Keating: We had a big discussion about this topic at our monthly Global Economics & Strategy Group meeting (GESG) at the end of August. Our view was that the economies are of course slowing down. The economic indicators show this. But we don't think there will be a double-dip recession. If you look back historically, it?s very usual 18 months into a recovery to have a bit of a slowdown. It?s linked to the way the inventory cycle operates.
So yes, there can be another 6 months or so of a bit more sluggish growth than it was. But we think the recovery will continue.

You sound quite optimistic. Which countries or region are outperforming right now?

At the moment continental Europe and the UK have been doing better than the US. It?s not clear whether this gap will continue. It may equal up in the next six months or so.
The bigger picture is of course the emerging markets. They are moving ahead very very strongly, while the developed economies as a group - the US, Europe and Japan - lag behind. That has been a new path of a structural theme which will carry on.
This does not mean that emerging market don?t have minor cycles. It looks likely that China will be growing slower in the coming months than it was earlier this year. But these are relatively minor fluctuations. Emerging markets are where the growth is.

Is a Japan-like deflation scenario an issue anywhere?

In Japan itself we currently have a minor deflation. It is not anywhere near the one that hit Japan during its lost decade at the end of the last century.
If we look at America, continental Europe and Switzerland we have inflation at a very low level. There is a risk that we could dip into outright deflation. But we don?t think that is anywhere near a central scenario. One of the reasons is the economic view just mentioned; another reason is that the banking sector is beginning to return to health. Banks have been recapitalized, helping to reduce the risk. The problems of the euro zone debt that were so concerning earlier this year, with fears that they could spill over into the banks and the real economy and thus create deflation forces, have for the time being deferred by the Financial Stability Fund.
For all these reasons, deflation is relatively unlikely. On top of this, the US and European central banks authorities are also determined not to let it happen. They would step up there bond purchases even more. That is not an easy option, but would help reduce deflation risk.

When can we expect the global economy to pick up again?

If this historic pattern repeats, we will basically go through a period of slower growth for about six months, through to the end of this year and into early 2011. As we go through the first part of next year, we will see a mild reacceleration. Based on how the inventory cycles operated in the past, that would be the normal process. That fits with the idea that we do not have major impediments from the banks.
Of course some people are worried that government cut backs could stall growth out. That is not something that the GESG agrees with. We are well aware we will have some headwinds from these cutbacks, but those effects will be smaller rather than larger.

Do you expect the world?s central banks to start raising their rates as a result?

At the moment, we have rates near zero in most major developed countries. One should expect that to continue for a very prolonged period. Investors everywhere should be well advised to position their portfolios on the base of zero as being the norm in terms of cash return, with an effect that shorter-dated bonds also have yields very close to zero.
The likelihood of the Federal Reserve raising interest rates next year has now become very low. We could see minor moves in the euro zone, in Switzerland and in the UK in 2011, but they will still remain very very low in the major developed countries.
Obviously in emerging markets and in some commodity-linked developed countries such as Australia, there have been rises and it is quite likely there will be more.

Let?s turn to the equity markets: the second-quarter earnings season which is now winding down was overall strong. How are the figures for the current quarter looking?

(Second-quarter) earnings estimates were revised up by analysts. That is particularly true in emerging markets, such as Asia.
As we look forward, we suspect we are coming to an end of this round of upwards revisions. In our view, that is not the start of a major downturn. This means we had a white heat of upward adjustment of expectations and from here on we will have more modest movements.

On the currency markets, the euro recently reached new lows versus the Swiss franc. Do you expect further euro weakness?

We are coming toward an end of that movement. The franc still has the structure to perform very well, remaining one of the stronger major currencies over the coming months. But we don?t think there will be further surges on the Swiss franc, on the scale that we have seen.

How about the US dollar?

It?s a rather similar story. The dollar/euro rate is beginning to stabilize in a range of 1.25-1.34. That puts the euro at the lower end of this band as we record this interview, suggesting it?s got some scope to move up.

How should investors act in the current environment?

Essentially we feel this is a market where equities remain fair valued. From a strategic sense, investors should be buying on dips and building up strategic exposure.
Many private, but also institutional investors are very concerned about the (current) uncertainty. This is not going to be resolved quickly. Those (underlying) issues are not going to become much clearer in the coming months. For those investors, we would recommend strategies which are designed to give good in upside in the macro environment we are talking about, while dampening down the downsize risk.
This means financial instruments like convertible bonds, higher-yielding equities and also strategies connected with emerging market currencies. The option pricing of these currencies is very attractive based on the condition that they may rise against the dollar, euro and Swiss franc. Bonds denominated in these currencies as well as some bank bonds, which are still lagging behind corporate bonds, are also of interest. Bank bonds have been lagging as investors are concerned about the underlying regulatory issues. These issues are now going to retreat.
All of these are interesting opportunities that have a degree of upside. A final one is alternative investments.

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