Greg Fuzesi and Marta Mastoni of JP Morgan note the difficulties of forecasting in the current environment. “Exogenous factors such as global demand, commodities and confidence can override domestic fundamentals. Forecasting these has been very difficult because the financial market stresses have taken numerous unexpected turns during the year,” they note. “A broader definition of fundamentals would include the credit cycle, which can be a very powerful drag and driver of growth. Credit cycles are often driven by expectations about incomes and prices, which may or may not be sustainable. It is now clear that when the credit cycle turns, with reduced credit availability and lower asset prices, leverage levels will suddenly appear much more burdensome to firms and households, and this can lead to a deep retrenchment.”

Past crises have been more contained, involving one asset class or institution. The global nature of the current crisis, however, has been less discriminate, impacting all economic indicators and spreading across all risk assets and geographic zones, according to Natixis. This suggests that past approaches will prove to be insufficient in finding a solution to the crisis. Today’s situation is reminiscent of Japan during the early 1990s. It is clear what happened there despite Japanese policymakers’ expansionist monetary policies.

Natixis cites a number of uncommon scenarios which can reignite growth in 2009: a drop in raw material prices can contribute to a meaningful increase in purchasing power; second, an expansionist fiscal policy, one that will encourage consumption and investment. Such a policy would also be underpinned by a zero percent interest rate policy in order to assist indebted entities to scale back their debt; third, the introduction of new products and services (the environmental sector) can create a new source of demand. “Even if public authorities succeed in reducing the high levels of debt assumed by different economic actors, it will be difficult for credit to once again be the motor of a new economic upswing given its powerful expansion in recent years,” notes Natixis. “Until mid-2009, the dominant themes in the market will be security, liquidity and simplicity.”

Economic Volatility

We have seen heightened market volatility this year. The same can be said about economic forecasts. In the last two weeks, our surveyed economists have recurrently lowered their forecasts. As a result, their three to six month forecasts (end of March and end of June 2009) at the start of January are lower compared to December for both short and long-term rates. The consensus median forecast for the ECB is set at 2% at the end of March and at 1% at the end of June. It has taken a while, but finally the ECB too has started to ease. Aggressive easing by the Fed took most economists by surprise as they were forecasting fed funds at 50 basis points last month. Virtually all of the economists expect a continuation of the Fed’s zero interest rate policy during the next six months.

Deutsche Bank has the most negative forecast for the eurozone. The 10^th anniversary of the euro will coincide with the sharpest recession since 1950. Deutsche Bank estimates that deflation has been under-estimated and that eurozone recession will extend into the second quarter of the year. Applying the Taylor rule, one obtains three month Euribor at 1.25% and the repo rate at .75bps. Meanwhile, 10-year rates are expected to move between 2-3% until June.

The foreign exchange market has been equally volatile. The surveyed economists have forecasts that are more or less in harmony regarding sterling. The currency is expected to stop its depreciation versus the euro. The euro/dollar rate is forecast at 130 on average. There are two camps concerning the euro/dollar; the first is betting on a lower euro/dollar rate, notably Citi, Merrill Lynch and Societe Generale. The second camp, which includes HSBC and Unicredit, is forecasting a rise in the euro/dollar rate. The Fed’s strategy of quantitative easing has fermented a lot of discussion among economists, notably for being a driver of future macro-financial developments. While at some point in the future the Fed will have to stop its policy of quantitative easing, the ECB has little room to follow such a strategy due to technical and regulatory constraints.

MN

Consensus January 2009