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>World Financial Markets: SECOND QUARTER 2010
• The global recovery will be maintained in 2010, lifting GDP at an above-trend 3.4% pace. The booming recovery in manufacturing will broaden to the service sector. The US will continue to outperform most other developed economies, reflecting more aggressive policy support and previous corporate cost-cutting. The EM will lead the recovery as strengthening external demand boosts exports while highly accommodative policies and generally healthy banking sectors support domestic demand.
• A continued positive feedback loop between financial markets, confidence, and consumer and business spending will drive the expansion in 2010. As fiscal stimulus wanes, improving labor markets that generate sizable gains in wage income and ongoing monetary stimulus will support final demand growth. Ongoing household deleveraging, corporate caution, and lingering banking problems in the US and Europe will keep the global recovery modest relative to the depth of the downturn.
• Massive output gaps will reduce developed market core inflation to 0.5%oya in 2010. This will prompt the Fed, ECB, and BoJ to leave policy rates on hold. Disinflation pressures are more limited in the EM, where there is less slack. EM policymakers will normalize cautiously; they are skeptical about the G-3 economic recovery and do not want to add to upward pressure on FX rates.
• The FX recovery trade faltered in midwinter. EUR and high-beta G-10 currencies were weighed down versus USD and JPY by concerns about Euro-area sovereign risk, policy tightening in China, and soft data, but Greece’s aggressive budget cuts and healthier data already have turned the tide in risk sentiment.
• We forecast a broad USD sell-off in the spring and summer followed by a rebound in the fall. The global upturn and strong profits will feed US cyclical capital outflows, and the Fed’s low-for-long policy encourages use of USD as a funding currency. But, shifting Fed rhetoric and liquidity withdrawals should prompt a USD rally in the fall and early 2011. With the BoJ lagging the global tightening cycle, rising capital outflows will undercut JPY in 2011. GBP likely will underperform, as a hung parliament breeds policy uncertainty, and continue to do so in 2011 amid budget cuts and private sector deleveraging. As global growth underpins commodity prices, commodity FX will continue to outperform, led by AUD and CAD.
• We expect US Treasury yields to drift higher as QE draws to a close and seasonal patterns play out. We target 2-year yields at 1.25% by midyear and 10s at 4.10%, and we expect the curve to flatten gradually over the course of the year.
• EM FX appreciation should endure through end-2010 as central banks tighten. EM growth is on track to reach 6.1%, above our 5.5% estimate for the long-term potential GDP growth rate, and 3.5%-pts higher than G-7 growth. Both EM Asia (7.9%) and Latin America (4.6%) are forecast to grow by more than 1%-pt above their potential growth rates; CEEMEA will grow slightly below potential at 4.2%. Watch rising inflation in EM, particularly in Asia and Latin America. Strong growth and increasing inflation pressures are prompting EM central banks to tighten monetary policy well ahead of their G-3 counterparts. We expect rate hikes in Brazil, China, India, Israel, Malaysia, Peru, the Philippines, and Thailand by June.
• We are overall positive on commodities. The outlook for energy turns more bullish in 2Q, when we expect an acceleration in price gains. We hold a positive view on base and precious metals in 1H, but do not expect further price appreciation in 2H as funding costs should start to rise.
To read the full report: WORLD FINANCIAL MARKETS
