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July 03, 2007
The World According To Goldman Sachs (And Almost Everyone Else)
From my email, "A Tale of Two Tail Risks," from Goldman Sachs' Michael Vaknin:
- Sub-prime mortgage woes still hold centre-stage as housing fundamentals deteriorate further.
- A full-blown spillover from credit markets to other asset classes is unlikely as corporate sector and global macro fundamentals remain strong.
- Rather, credit market will feature less leverage, more convents, elevated volatility and gradual supply absorption.
- Upward risks to global inflation also remain high on the list of what investors worry about currently.
- On our baseline case, prudent monetary policy should limit a build-up of inflationary pressures.
From a fundamental standpoint, there are two conflicting forces to consider. First, the ongoing deterioration in the residential housing market will continue to weigh on the mortgage market. Recent housing market data point to further inventory accumulation, while price indicators suggest the deceleration in house prices has gained more traction recently. The Case-Shiller 10- and 20-city composite indexes have declined sharply in April (7?% on annualized basis). The resulting decline in housing equity, along with the recent widening of mortgage rates and tightening of contractual mortgage conditions are all likely to keep credit investors on high alert.
On the bright side, corporate fundamentals remain fairly robust. Corporate default fundamentals are in good health, and from a macro perspective, corporate earnings are still supported by broadly favourable global demand conditions. While measures of industrial activity (including our Global Leading Indicator) have been somewhat softer than expected recently, from a level perspective the global manufacturing cycle remains comparatively strong, and a more broad-based weakness in the data is needed to shift this perception. Today's US ISM and the upcoming US payroll data are highly important in this respect.
That ISM report was, of course, a good one, although today's news on pending home sales failed to break the string of lousy housing data and factory orders for May were primarily lauded for being less bad than expected. But put it together and the consensus seems to be that it all adds up to the Goldman Sachs story. That's what came through in yesterday's round-up of forecasts from the Wall Street Journal, and the story that we're sticking to appeared again today in Bloomberg's coverage of the housing sales and orders reports:
Economists and the Federal Reserve predict growth will accelerate from its first quarter pace, the weakest since 2002, even as housing remains a burden. Fed Chairman Ben S. Bernanke said last month there was no sign of "major spillovers'' from the housing slide. Industry reports for June show manufacturers are raising production as businesses spend on investment.
"The second half is coming together almost perfectly according to the Fed's plan,'' said Mark Vitner, senior economist at Wachovia Corp. in Charlotte, North Carolina. "Housing is going to be a drag but if we get some strength in business spending then the economy will be able to handle it.''
Though some of the forecasters in that Wall Street Journal survey -- about 20 percent --- put inflationary risks at the top of their wish-not list, GS's Vaknin wants to ease their minds:
As global activity continues to grow at an above-trend rate and commodity prices remain elevated, a re-acceleration in consumer price inflation, particularly in the major markets, remains a clear risk to the outlook for financial asset returns. Consider that, on a year-on-year basis, headline inflation in advanced economies has accelerated from 1.7% in Q4:06 to around 2.0% currently, driven largely by higher food and energy prices. Such acceleration comes on the back of extended tightness in production capacity: According to the OECD, the output gap in this group of countries is about to move into a positive territory by year-end after hovering in negative levels since mid-2001.
Despite these seemingly worrying observations, we that think inflation, particularly in the G-7, should accelerate only moderately before stabilizing at benign levels early next year. Granted, elevated food and energy prices may keep headline inflation above core measures for a bit longer. But this should be seen in the context of two important developments: (1) US core inflation is on a genuine deceleration path, and (2) Monetary policy stance remains prudent in other major economies where upside inflation risks are clearly higher.
The "monetary policy stance" is key, and it probably explains why so many commentators are taking their predictions of a policy-rate cut off the table for the time being.
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