The key themes over the forecast period are likely to be driven by European stress tests, Fed meetings, minutes and testimonies, Chinese GDP and Purchasing Managers Index as well as UK inflation and consumer confidence reports.

European stress puppies are likely to be the dogs that don’t bark over the summer, but in conclusion we can expect the most plausibly optimistic central scenario. Politicians and regulators face a classic prisoners dilemma, where each country wants to give as many of its domestic banks a clean bill of health, but recognise that the €urozone as a whole will need to force combined capital increases of at least €80-90bn.

The stress tests are unlikely to alleviate market concerns over the eventual requirement for European restructuring. US Nobel prize winner Robert Mundell, and progenitor of work on optimal currency areas, estimates a 40% risk of Greece restructuring, while Spain, Portugal and Ireland have a 20% probability of restructuring and our favourite of the PIIGS, Italy has a 10% risk over the next few years.

The importance of these estimates is that a few months ago, Mundell would chop off his right arm before admitting the risks of restructuring the single currency. If the intellectual father of the €uro can rationalise its restructuring and potential break-up, then it is already in the price. The discussion in the Sunday Times provides a neat encapsulation of the problem: the PIIGS would be better outside of the deflationary system, if only they could find a means of divorce that does not include political suicide and the collapse of their domestic banking system.

This key point was emphasised by the Spanish auction last week, which showed good cover. This proves that there is demand for Spanish bonds at the right price: the syndication was set at 26bps over the existing 10yr bond. Further supply in the remainder of the month suggests that further concessions will be required, but investors are right to assume that volatility in peripheral spreads is likely to subside over the forecast period.

This does not mean that they are screaming buys, quite the opposite. We believe that the agenda is shifting from the European sovereign debt crisis to global economic slowdown. A double dip recession is not inevitable, but it is far greater than the zero indication provided by the yield curve. The yield curve is providing a false positive for the economy because short-term rates are anchored at zero; it is impossible for the curve to signal recession. As Keynes and Japan have proved, you can get recessions at zero interest rates.

Zero interest rates will be the focus of the Fed’s minutes on Wednesday, as well as the forthcoming FOMC meeting in three weeks time and the following Humphrey Hawkins testimonies. The Fed will argue that the stimulus of zero interest rates is sufficient to provide a modest recovery in activity through bank and consumer deleveraging as well as fiscal austerity. 

The Fed will point to the slowdown in 2002 as evidence of the peak in leading indicators at high levels as proof that the recent data does not signal a double dip. However, the Fed was sufficiently concerned in 2002 to cut interest rates in November and again in July 2003. More importantly, the Fed will argue (while it is confident that the economy will maintain modest growth rates) that downside risks have intensified.

The key figures to watch out for over the next month are the retail sales data, regional business sentiment indicators including small business sentiment, housing, durable goods orders, employment and the Fed’s own senior loan officers survey. Weekly retail sales were not as bad as feared and the heat wave contributed to an improvement in higher value added items at the end of the month, highlighting some upside risks to non-auto sales. But since auto sales fell by 5% during the month and energy prices were also weak, headline sales are expected to fall by 0.2-0.3% from upward revised levels in May.

This data is consistent with more consumer caution. Consumers built up savings during 2009 and then ran them down during the first quarter in anticipation of stronger employment data during 2010. Savings rates have stabilised around 4%, above the leveraged bubble but below their long-term average. Consumers have the means but do they have the will to continue spending.

The only thing that consumers have to fear is fear itself; if they maintain or even increase expenditure from the first quarter level they will give businesses the confidence to increase investment and employment, allowing the recovery to accelerate to escape velocity. Companies are doubly exposed to the twin paradoxes of fear and thrift. Corporate savings are at their highest rates for a generation, while investment ratios are low. They have ample incentive to increase investment as the limits to leverage and costs cutting are exposed. Over the past year companies have eliminated the gap between consumption and production but need to see more consumption demand to build inventories and move to the next stage of the recovery.

However, if companies are worried about the risks of the economic slowdown and consequently delay investment, then this will become a self-reinforcing expectation. The most disturbing aspect of the ISM manufacturing decline was the seven point fall in new orders. This makes the durable goods order data crucial to financial markets’ understanding of both second quarter GDP data and prospects for the second half of the year. Non-defence capital goods orders rose by 31% annualised rate in the three months to May, while shipments increased by 17.7% over the same period. This is consistent with growth of 3.5-7.5% in the preliminary second quarter estimate at the end of this month. However, there is also room for disappointment in the June numbers, which will provide a poor start to estimates of the third quarter.

Second quarter earnings are likely to be strong on the back of decent economic growth, but evidence of a poor end to the second quarter will weigh upon estimates of third quarter activity and consequently estimates of slower third quarter GDP growth. We believe at this stage the slowdown will be modest, with 2.2% growth pencilled in for the third quarter.

Housing will be one key area of weakness in the third quarter. Last month, housing starts fell by 10%, pending and new home sales fell by more than 30%, and the NAHB index fell from 22 to 17, close to its all time low. The weakness was caused by the ending of Federal subsidies and is payback for improvements at the start of the quarter. However, this was mafia payback with the correction greater than the prior boost. Existing home sales are expected to fall by up to 30% in June, but the focus will be on new home sales to see if there has been any bounce from these “oversold” levels. Mortgage purchases have continued to contract during July, after a 15% decline in June and 17% in May, despite continued decline in mortgage rates.

The 3 point fall in the ISM manufacturing index was greater than implied by the regional business sentiment indicators. Sentiment indicators tend to have a high degree of monthly autocorrelation, but a bounce in the regional indices such as Philly and Richmond Fed and/or the July ISM would not be inconsistent with our gradual slowdown thesis, although they will undoubtedly affect short-term market sentiment.

However, the most important indication of the consumer and corporate fear factor will be determined by the SLOS. The recovery in banking profitability over the past year should provide another easing of lending conditions, but like the Bank of England’s survey released 10 days ago, the easing of restrictions over the past three months is likely to have been less than expected due to weak demand. The sharp decline in consumer credit in the past two months is evidence that the US is following Japan in that it was not the supply of credit that was decisive in determining deflation but the demand for credit.

This underlines our view that the next couple of months could provide some volatility in the economic data after greater than expected weakness during June, but the trend is clearly towards slower economic activity, greater threat of deflation and continued extension of the bull market for government bonds over the medium term. Recession is not inevitable; politicians could offset some of the 2% of GDP tightening of fiscal policy (split 1% Bush tax cut repeal and 1% state and local government tightening) due over the next year, but the approach of mid-term elections in which all of the House of Representatives and 36 Senate seats are up for re-election are hardening the resistance of the Republicans to any stimulus measures. The tide is turning against hope and current opinion polls suggest that the Democrats will lose their majority in the HOR, reducing significantly President Obama’s ability to offset this fiscal austerity next year (cf, the Sage of Omaha’s favourite bedtime reading “When the Money Runs Out” about hyper-inflation in Weimar Germany).

Recession can be avoided through liberal use of quantitative easing. However, as per his 2002 speech, Bernanke is likely to try to guide long-term rates lower following the example of the 1950’s when the Fed set targets for the term structure and investors adhered to these strictures. However, the treasury market was almost entirely domestic in the fifties, whereas it is now 60% owned by overseas investors, who are likely to take a dim view of interest rate targets suggesting that moral-suasion will fail and that massive and sustained purchases of treasuries will be required.

The Fed will not buy mortgage bonds in QE2. It does not want to create another bubble in housing, but it will buy treasuries. Press reports have suggested that Bernanke wants to double the size of the Fed’s balance sheet to $5tr, if only the regional presidents will agree. It will take time and a plethora of weak data to persuade these recalcitrant FOMC members to agree further QE.

The prospect of weaker economic activity over the autumn and winter will resume widening of peripheral European government bond spreads over the period. The justification for this will be twofold. First, liquidity is likely to be at a premium in the next big bond market move, big is beautiful. Secondly, the next global economic slowdown is likely to be deflationary. Fiscal austerity is already driving internal deflation amongst the PIIGS, additional global pressure will further damage investor sentiment. Equally concerning will be the bank funding concerns from financial institutions that have $5tr to refinance over the next couple of years ($1.3tr in US and $2.3tr in Europe).

The G20 meeting in Toronto placed a great deal of emphasis on China to save the global recovery, but China is too small and selfish to save the world. Chinese second quarter GDP growth is due on Thursday and is expected to match consensus expectations of 10.5%, down from 11.9% in the first quarter. Chinese growth peaked in the first quarter and is slowing more rapidly than expected. Latest export data notwithstanding the key figures are likely to be next month’s PMI data. June was depressed by three extra days holiday, but we expect concerns over global slowdown to keep indices around current levels in July before dipping below 50% in August or September. This will be the trigger for more government stimulus, but the law of diminishing returns suggests that this second package will not be as large as 2008, nor as effective in boosting international investor sentiment. There are too many investors waiting for Chinese stimulus with baited breath.

The UK is likely to be the quietest of major economies this month; little will be heard from the MPC ahead of next month’s Inflation Report. CPI data later this week is expected to slow the annual rate from 3.4% to 3.2%. This is the measure that the Bank is tracking for policy. It is also tracking average hourly earnings, which are likely to rise slightly over the summer due to base effects, but remain weak on an underlying basis as job opportunities and public sector pay are both restrained.

Consumer confidence is the key to the next stage of the UK recovery. Retailers surveys suggest that consumer spending has been disappointing over the past couple of months and this has been reflected in weaker consumer confidence. The gfk index for consumer confidence has fallen by 4 points over the past four months, while the more volatile Nationwide survey showed its largest monthly fall for two years last month.   

We believe that a double dip global recession is likely but not inevitable.  Global leading indicators have peaked and are disturbingly reminiscent of 2002. America provides the most obvious evidence of this peak with regional business sentiment indicators, consumer confidence and the weekly ECRI (Economic Cylcle Research Institute) leading indicator all highlighting the likelihood of a sharp slowdown over the next twelve months. Other countries are also showing evidence that growth has peaked. UK consumer confidence has fallen for four successive months as consumers react to headlines of severe fiscal austerity. Fiscal austerity in peripheral European economies has also dampened sentiment and activity indicators.

Fiscal austerity in individual economies does not necessarily signal recession. There are plenty of historical examples of successful fiscal consolidation, but these have been pursued by individual countries and highlight Keynes’ paradox of thrift whereby individual saving is good, but universal saving is counter-productive because it is likely to reduce aggregate demand and lead to higher deficits. Increased government saving can be offset by reduced consumer or corporate saving, but the contraction in bank lending due to consumer, financial and corporate deleveraging suggests that this is unlikely to occur.

Recession is not inevitable despite clear evidence of slowing activity. In 2002, the Fed responded to the peak in global leading indicators and threat of deflation by cutting its funds rate by 50bps in November and a further 25bps in June 2003. This prevented a double dip, although domestic demand growth was close to zero. The current environment of near zero official interest rates means that any further rate cut will involve quantitative easing to create effectively negative interest rates.

Agreeing QE in the depth of a recession, with concerns over the health of the financial system, was relatively easy last March but it will be much more difficult to achieve unanimous support when recoveries are slowing. Regional Fed Presidents, Hoenig and Plosser in the US, MPC member Andrew Sentance in the UK and the entire staff of the Bundesbank in Europe have all expressed their opposition to unconventional measures. But failure to counter fiscal austerity and slower growth will ensure a double dip. In the event of a double dip, quantitative easing is inevitable.

The Fed will undoubtedly be disturbed by the growing paradox of thrift amongst consumers and corporates. There is ample evidence of this paradox in the latest ISM (Institute of Supply Management) manufacturing and service sector data as well as weak employment growth for businesses. Consumer concerns are evident in the decline in May retail sales, fall in June consumer confidence, relative collapse in new and pending home sales in the wake of incentive repeals, as well as lead indicators showing another fall in retail sales during June.

The most effective means of countering the paradox of thrift is further unconventional monetary policy in the form of quantitative easing and buying of treasuries. The most likely timing of these purchases is next January or February, but this time scale could be shortened by disappointing third quarter earnings data or a more rapid descent into deflation. In the meantime, Bernanke is likely to extend the lower for longer language.

There is no fundamental reason why slower growth and the increased threat of deflation in the US are bullish for export dependent Europe. But the single currency has gained temporary relief from negative domestic headlines to focus on the shift in technical indicators and short term interest differentials. This dead cat bounce could drive the €uro all the way to $1.30-35 before the €uro bear market resumes.

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Chancellor George Osborne has obeyed Rahm Emmanuel’s (Barack Obama’s Chief of Staff) famous maxim; “You never want a serious crisis to go to waste. And what I mean by this is it’s an opportunity to do things that you could not do before”, to intensify the fiscal austerity proposed by the previous government in order to rebalance the economy away from unproductive areas of the public sector towards productive sectors of the private economy.

This can be characterised as choosing the pearls of the private sector over SWINE, where this latest acronym refers to Scotland, Wales, Ireland (Northern) and the North East, where the share of government expenditure is particularly high in relation to the private sector.  The government has reinforced this strategy by focussing 80% of the deficit reduction on expenditure cuts.

Additional plans for fiscal consolidation amount to £40bn per year by 2014/15. £32bn of this saving will come in the form of additional current expenditure cuts, with no further planned cuts in capital expenditure.  These current spending cuts will be announced in the Autumn Spending Review, which will be delivered on October 20^th.

A key part of these current expenditure cuts will come from welfare reform, including the adoption of the consumer price index for indexation of tax credits, public sector pensions and welfare benefits from next April. The Chancellor also announced a public sector pay freeze over the next two years for public sector workers earning more than £21,000, whilst those earning less will receive a fixed pay award of £250 per annum.  £8bn of the additional fiscal restraint over the next four years will come from tax increases, including an increase in the VAT rate to 20% from January 4^th 2011.

This additional tightening represents 2% of GDP over the four year period and together with the previous government’s target represents a net tightening of fiscal policy equivalent to 8% of GDP.  This is not as great as the austerity proposed by the PIGS of Portugal, Ireland, Greece and Spain and reflects the greater flexibility of the UK economy provided by monetary and foreign exchange. The Chancellor reinforced this message by closing the Euro preparation department and promising to maintain the Government’s opposition to joining the single currency.

The emergency budget should satisfy two immediate aims of maintaining the UK’s triple AAA sovereign credit rating and enable the Bank of England’s Monetary Policy Committee to keep base rates at their current emergency level of 0.5%. The global shortage of genuine triple AAA assets should help to maintain strong international inflows into the gilt market and prevent the UK from becoming another casualty of the European sovereign debt crisis.

The Office for Budget Responsibility (OBR) has won the OBN (Order of the Brown Nose) for the second week running by predicting that the heightened austerity would only reduce growth by 0.3% to 2.3% next year, while the forecast for 2012 was left unchanged at 2.8%. We have absolutely no doubt that the positive rebalancing of the economy will help support longer-term productive potential and offset the adverse demographic impact of the aging population. However, it is naïve to assume that the improvement will be instantaneous. As we noted last week, the OBR’s forecast is heavily reliant upon a rapid recovery of corporate investment and export demand. The prospective tightening of fiscal policy in Europe, the US and Japan over the next few years suggests that global growth will be significantly weaker than the OBR’s models have assumed. Leading indicators have already peaked, and net exports will consequently provide a considerably smaller contribution to growth over this period.

Likewise, the OBR has fallen victim to the fallacy of spot rates by assuming that the relatively low level of 10yr spot gilt rates provides a powerful incentive for corporate investment. However, this 10yr spot rate represents an average of the forward rates for this period. The average is anchored by base rates at 50bps, and as the chart below of the forward interest rate curve shows, these forward rates rise rapidly from this base. One year gilt yields, projected nine years forward, are above 5%.  We do not believe that this is conducive to the investment boom that the OBR expects.  We believe that this investment boom will take place, but will be triggered by further quantitative easing from the MPC designed to drive down these forward rates and provide a genuine incentive for record corporate investment. The domestic and global economy, as well as global inflationary trends, will have to slow further over the next year to provide the MPC with sufficient justification to resume QE on this massive scale.

The emergency budget is bullish for gilts and Sterling.  We believe that Sterling has greater potential to rally against the €uro than the US Dollar, where enthusiasm will be tempered by the maintenance of record low interest rates.  The budget should reduce the sovereign risk premium for gilts, although initial enthusiasm will be tempered by the fact that investors had already discounted a fall in gross gilt funding from £187bn to £165bn and the unadventurous way in which the Debt Management Office distributed these savings across the market sectors.

The much maligned forecasts from HM Treasury that underpinned the previous Labour Government’s justification that further aggressive fiscal tightening is unnecessary and that the economy could grow its way out of its current unsustainable budgetary position were based on the most plausibly optimistic forecasts. 

Drawing from past experience of the fiscal tightening in the wake of Sterling’s ignominious exit from the Exchange Rate Mechanism, when Sir Alan Budd, the new head of the Office for Budget Responsibility, was Chief Economic Advisor to the Treasury, the deficit as a percentage of GDP fell from 8.3% to 3.7% and the economy achieved growth of more than 3% per annum. These forecasts hark back to a halcyon time of strong global growth, buoyant domestic employment growth and strong bank balance sheet expansion.

The sovereign debt crises in Europe, where the weak peripheral members no longer have the option of following the UK example of currency devaluation, have forced a more sobering assessment of the economy’s prospects. Nevertheless, the new forecasts are the most plausibly optimistic under these more straightened circumstances.  The real GDP growth forecasts over the next few years are lower than the previous Treasury forecasts, but noticeably higher than consensus economic forecasts for the period. The forecasts rely upon an investment and export boom to drive employment and real incomes.

An investment boom is possible in the future, but not yet. The chart below of the forward curve shows that medium term forward rates are too high to drive the necessary investment boom. We believe that the initial impact of severe fiscal retrenchment will be a significant slowdown in economic activity, which will force the MPC to resume quantitative easing in order to drive these medium term forwards to levels sufficiently low to drive this investment renaissance.

In the meantime, OBR optimism apart, the Chancellor is likely to announce a package of tax measures at next week’s emergency budget totalling £8bn. Combined with the £5.7bn worth of efficiency savings announced recently, this will bring the additional cumulative tightening to 1% of GDP, satisfying the requirements of the rating agencies to retain our triple AAA sovereign rating.  This package should be bullish for forward gilt rates.

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The newly formed Office of Budget Responsibility will publish its first set of forecasts for the UK economy as well debt and deficit estimates for the next few years on Monday 14^th June, which will form the backdrop to George Osborne’s emergency budget on June 22^nd.  The OBR will undoubtedly become an important feature of British economic and political landscape over the next few years, but we very much doubt whether this forecast led by former MPC member Alan Budd will differ significantly from consensus economic forecasts over the next two years.  This means that the OBR is likely to forecast real GDP growth of 2.3% during 2011 after an expansion of 1.3% in the current year. The National Institute of Economic and Social Research estimate of quarterly growth for May of 0.6% is consistent with this forecast of 1.3% for 2010. This is lower than the previous Treasury estimate of 3.0% for 2011.  Gordon Brown’s highly politicised Treasury also provided the most plausibly optimistic forecast of 3.25% per annum between 2012 and 2014 helping to lower the deficit as a percentage of GDP to 4% by 2014. A number of forecasters have suggested that the OBR could plausibly forecast 2.75% growth during this period.  However, we believe that it will be more circumspect given the recent heightened level of macroeconomic uncertainty and volatility, maintaining the downward forecast of 0.7% relative to the Treasury’s previous optimism.

The prospective 2.5% growth rate is consistent with the Bank of England’s estimate of the economy’s long-term productive potential. It also provides a sobering assessment that the loss of output during the credit crunch is permanent and that the best the economy can hope for is a return to trend growth rather than catch-up.  We believe that even this new realism, is too optimistic and that growth will disappoint these lower forecasts as global fiscal austerity, at a time of continued deleveraging of personal and financial balance sheets, will prompt the paradox of thrift and a deficiency of aggregate demand amongst the major industrialised economies, which in turn will lead to mild recession amongst the major industrialised economies during the second half of 2011.  However, the lags involved in fiscal policy are sufficient that this outlook is beyond the immediate horizon of the newly CON-DEMned coalition government, and indeed the rating agencies, which is firmly focussed on deficit reduction.

Ceteris Paribus, a 1% reduction in GDP leads to a 0.7% increase in the budget deficit as a percentage of GDP according to the Treasury’s own estimates. This suggests that the deficit estimates will be 0.5% higher per annum than previously estimating, increasing the task of the new government. However, fortuitously there is a balancing item from the Treasury’s previous estimates. In the March 2009 budget the Treasury estimating that the structural deficit amounted to 9% of GDP and that the overall budget deficit would be £168bn during the forthcoming 2009/2010 fiscal year. Happily the outcome turned out to be nearly 2% lower despite weaker than expected GDP throughout most of the period. This suggests that in kitchen sinking the deficit, the officials over-estimating the structural component of the budget by an equal amount.

Of course this does not absolve the Government of having to produce the largest tightening of fiscal policy since the War. The Government has adopted the stance beloved of plumbers and management consultants everywhere, of describing the situation as “worse than we thought”. This WTWT stance adds to the dire warnings from the ratings agencies. As Fitch noted in its recent report on UK public finances; “the scale of the UK’s fiscal challenge is formidable and warrants a faster pace of medium-term deficit reduction than set out in the April 2010 budget.  The new coalition has already made a start with a package of measures to reduce expenditure by £5.7bn. However, this represents just 0.4% of GDP, while pales in comparison to the hair shirts adopted by the Southern Mediterranean economies. The Fitch report proposed that fiscal policy should be tightened in order to lower the deficit as a percentage of GDP by 1% per annum, allowing the deficit to fall below 3% of GDP by 2014.  This suggests that an additional package of tax hikes is required on the 22^nd.  We believe that additional tightening will amount to £8bn.

Predicting the exact composition of secretive Treasury tax proposals is a mugs game, but the policy of preparing the electorate for the pain of fiscal austerity, as well as the respective coalition parties’ election manifestos, has thrown up a number of proposals, which by no means exhaustive; provide a clear indication of the scope of the emergency budget.  The coalition has promised to raise the rate of capital gains tax on non-business assets such as shares and second homes and despite a concerted campaign from the Conservative media, the Chancellor is likely to propose increases in this rate, although we expect the start date to be delayed until April 2011.  Immediate tax hikes are likely to come in the form of increased sin taxes on alcohol and tobacco, which will raise around £300mn.

However, when the Government is looking around for low hanging fruit to tax, the corporate sector is easy prey, particularly the financial sector, which is likely to be hit by the extension of the bonus tax as well as a new levy on banking profit, which together will raise as much as £4bn.  There are other industries that will feel the Chancellor’s light fingers over the next few years such as pharmaceuticals and utilities, but we believe that they will escape scrutiny in the short-term for the time being. Indeed, the Chancellor could follow through his manifesto promise to lower corporation tax by 3% although this would be fully funding by closing of loopholes and reducing depreciation allowances. On the other hand consumers are likely to be hit by two separate tax hikes. The air passenger tax is likely to be increased in order to raise an additional £3bn, while the Chancellor is likely to announce an increase in VAT to 20%. This hike, which will raise more than £11bn in a full fiscal year, is likely to be delayed until January 1^st, in order to minimise the inflationary and welfare consequences of the move.  We do not believe that the Chancellor will move to extend this tax to zero weighted items at this stage given the regressive nature of the tax, but it will clearly become the subject of intense debate next spring as he addresses the need to reduce the deficit by an additional 1% of GDP next year.

The main focus of this debate will be the reduction in government expenditure in general and welfare payments in particular. Additional spending cuts of £45-50bn will be required over the next four years. Much of this will be achieved through reduction of expenditure on the middle classes. An early candidate for savings may be adopted in the emergency budget by restricting child tax benefit to 13yrs olds rather than the current policy of 19yrs. This would help to save £3bn.  

We expect the emergency budget to reduce the budget deficit forecast to £145bn, which will lower the percentage of GDP below the psychologically important 10% level to 9.9%. We believe that this will be crucial in determining the response of the rating agencies with both Fitch and S&P expected to give their opinion within days of the budget presentation.  We believe that both will maintain the UK’s triple AAA sovereign credit rating. This will allow total gilt issuance to drop to £168bn in the current fiscal year. We believe that this will allow the gilt market to continue its outperformance against other riskier European sovereign credits, including France. Sterling should also benefit from this retention of triple AAA rating. In a world where triple AAA assets are in short supply, reserve managers are likely to increase their weightings in Sterling, allowing it to appreciate further against the €uro.