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The future is an impossible place. Every year the world’s financial pundits have a go at forecasting it and pretty much every year they are wrong. Indeed, if they had any sense they’d have given up long ago. Still, they haven’t, and no one appears to mind much if they keep getting it wrong – the financial commentary market seems to be a remarkably forgiving place. With this in mind, we’ve asked some of our writers and some of our favourite analysts to tell us what they think might happen during 2006...
Risk 1: The US consumer will stop spending
“The joker in the pack” for the world economy in 2006 is US consumers, says Tom Stevenson in The Daily Telegraph. Their appetite for spending has been one of the “great economic surprises of 2005”. And whether their spending keeps rising will be one of the most important factors for world economies and markets in 2006: consumption makes up 70% of US GDP and supports 20% of the global economy, so if US shoppers slow down, so does the rest of the world. The bad news is that the US consumer is soon going to have good reason to slow down.
Over the last few years, household spending in America has been rising much more rapidly than wages thanks to the fact that house prices have been rising (up 60% in the last five years), hence allowing Americans to withdraw equity from their homes for spending. The Federal Reserve estimates that American householders have been removing $600bn every year since 2003 – equivalent to 6% of personal income – and that 50%-60% of that money has been used to fund consumption. This would be fine if house prices could be counted on to go up for ever. But they can’t be. Interest rates have been rising for some time now in the US and there are still more rises to come – analysts expect rates to go up twice more in the first half of 2006 and the effects of this can already be seen in the market: mortgage applications in the US are now at a three-year low and there are anecdotal reports of falling prices coming from many of the areas where prices have risen most, such as Florida.
This cooling of the housing bubble, says Oxford Analytica, “will significantly curtail household extraction of equity from the property market”, which will in turn “curtail the growth of consumption”. That’s not good news for anyone. But it is particularly bad news for US retail stocks, Brett Gallagher, head of US equities at Julius Bear Investment Management told Reuters. The US holiday shopping season was much hyped, but don’t expect the good cheer to endure: Wal-Mart has already said that Christmas sales came in at the low end of their estimates and, overall, US retailer and consumer discretionary stocks are poised to be “among the worst performers in 2006”.
Risk 2: Inflation will keep rising and bonds will fall
If the latest US statistics are any guide we can expect inflation to keep creeping up in 2006. The broadest measure of price changes in the economy is the GDP deflator, and the US figure for the third quarter has just been revised upwards from 4% to 4.2%. The 4% figure was already the highest since 1991, but “the final calculation of 4.2% brings the inflation back to where it was at almost the very beginning” of the long decline since 1982, says Edward Hadas on Breakingviews.com. Given real inflation of this size, the current ten-year Treasury rate of 4.5% is a paltry return, so why are investors accepting it? Because these days few market participants remember the bad old days (between 1969 and 1982 the GDP deflator averaged 6.9%) and have ignored the fact that inflation has been creeping up steadily for the past four years. “Bond investors might want to check their history books” – and when they do, expect them to demand much higher yields and bond prices to fall as a result.
Here in the UK, government bonds are also looking overpriced given the inflationary outlook, according to ex-Treasury adviser Tim Congdon in Money Observer. Presently, gilt yields are 4% to 4.5% and the inflation target is 2.5% on the old Retail Prices Index. But “there is a lot of history to say that the correct long-run yield on government bonds should be about 3%”. If you add 3% to inflation of 2.5% that gives you 5.5 – “so yields are too low” – again because investors are too sanguine about the prospects for inflation. UK inflation above 3% this year is well within the bounds of possibility, and sooner or later gilt prices will fall (and yields rise) to reflect that fact.
Risk 3: Security
“The number-one risk to global growth over the next few years has to be the global security situation,” says Kenneth Rogoff of Harvard in the FT. Imagine if there was an incident on a container ship – it would “wreak havoc across today’s far-flung global supply chains, effectively constituting a huge tax on global trade,” with far more “dire economic implications” than a localised disaster.
Risk 4: Oil
“The risk at the cusp of the non-economic and the economic is our insatiable demand for energy,” says Martin Wolf, also in the FT. We will need “four new Saudi Arabias” to feed our appetite by 2025 – creating a “big accident waiting to happen”. US billionaire Richard Rainwater is kept awake at night by this one too. He thinks we’ve reached the point at which oil will always be a diminishing resource, and that when people get blindsided by prices rocketing past any level they have contemplated, ”everybody will riot”, he tells Fortune.
Risk 5: The dollar
This year it really might collapse, says Stephen Roach of Morgan Stanley. Although it may start off 2006 with last year’s momentum still behind it, “watch out for a reversal in early 2006” as the yen and Chinese yuan appreciate fast.
Risk 6: The pound
If Blair resigns this year, Brown will have to face “a weakening economy, a widening budget deficit, and with none of the international goodwill Blair enjoys”, says Matthew Lynn on Bloomberg. Then the pound will tumble.
Risk 7: China
The emerging giant could see a “sharp slowdown in bank-funded fixed asset investment”, says Roach, which could turn its boom into a “breeding ground for excess capacity and deflation”. This could then, thanks to China’s enormous size, lead to “surprising drops in oil and other industrial commodity prices.
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Annunziata Rees-Mogg
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