Global Slowdown Is Part of Natural Cycle

12.11.2007 Oil prices are surging, the dollar remains weak and the sub-prime crisis is still ongoing. While there is a slowdown, Giles Keating, Head of Global Research for Credit Suisse, sees it as part of a natural cycle and emphasizes the opportunities of the current state of the world economy. Joy Bolli: What are the reasons for the current market turbulences?
Giles Keating: Investors are really very worried about the financial sector. They are concerned that the knock-off effects from the sub-prime crisis are eroding bank profits and bank capital. They also think that the US Federal Reserve (Fed) might have to ease interest rates yet again to deal with that. And they are worried that by doing so the Fed might undermine the dollar. As a result, that is depressing the dollar and is generally creating a sense of greater uncertainty than we have seen in the last few months.

The Fed recently made another rate cut. Hasn’t that helped to ease the worries?
There is a feeling, which has really developed in the short space of time since the Fed did that last cut, that that cut wasn’t enough and that the credit problems are becoming worse. Therefore, the Fed might still have to do more.

We have been talking about the sub-prime crisis for many months. How is that developing?
The problem is that know one completely sure just how deep it’s going to get. We have seen the price of sub-prime debt in the market getting lower and lower even over the period following those two rounds of Fed rate cuts. This is regarded as a potential problem for some of financial institutions. Indeed, the price in some cases has fallen to as low as 20 cents on the dollar. At that level, it means that the financial institutions holding that debt really must mark the prices down. Of course, it may turn out that in 12 to 18 months time, that the price of 20 cents on the dollar is too low, and that the respective debt is worth more. We believe it is probably worth more than that. But the reality in the markets at the moment is that you can’t sell it for any more than that. In fact, you even have to sell it at that very low price, and that’s what’s causing the problem.

What effects has this had on markets outside of the US?

There certainly is a kind of spillover effect developing here. But we consider this a short-term effect, which is extremely unpleasant while we’re passing through it. But we believe there are longer-term reasons why we will see a recovery. However, for the short-term, clearly what’s happening is that as investors see the risk of further Fed rate cuts, they see the dollar tending to go down and that makes them concerned that the dollar decline could accelerate and become unstable. That tends to encourage people to buy gold and make them cautious to hold certain equities which they were feeling optimistic about until very recently. That kind of short-term concern in markets can last for quite a long period. But it won’t be long until people look through those short-term problems to a more stable period ahead.

Gold is often considered a safe haven such situations. What other commodities are of interest?
We are seeing oil prices and most commodities prices looking fairly strong in response partly to the weakness of the dollar, which makes people keen to hold physical assets such as gold. On top of those effects which are a kind of mirror images of the dollar weakness, there is a sense that the demand for many commodities that remains pretty robust. While we are in a bit of a slowdown in the United States and Europe, Asia continues to be very strong. China, India, and other countries in the region really still have a lot of forward momentum, and that is keeping up the demand for these commodities. Our view is that we are almost going into an over-shooting phase for some of them. Oil, for example, has obviously been trading very close to the100-dollar mark and it is not impossible that it could surpass it at certain times. Although at a two- or three-year view that level might be sustainable, our feeling is that the short-term supply and demand position means that there is likely to be a bit of setback before the longer-term trend resumes.

How will the prospect of triple-digit oil prices impact major importers such as China?
A lot depends on whether that price stays very high for a long time or whether it reverses quite quickly. If indeed this turns out to be a kind of speculative driven spike and the prices go up, then reverse again quite quickly to around the 80-dollar mark, then my guess is that the impact of this is really not that great. If it goes up much higher and stays there, then we are in a rather different situation. Even then, it depends on why the prices are staying high. If the reason were severe short-term supply constraints, then I would see that as potentially quite damaging. But if – as is more likely – they were to stay high simply because demand was very strong, then we would find ourselves in a circular situation where the reason oil prices are high is because, for example, the Chinese economy was very strong. And yes, the high oil price then might tend to break it up a bit, but it would be bringing it back from a rate that was perhaps already too strong.

While there are worries about the dollar’s weakness, the Euro is going strong. Why?
Largely because the strength of the euro is clearly, again, the mirror-image of the dollar weakness because it is not just the euro that is strong, it is many other currencies including the Swiss franc, Canadian dollar, Australian dollar, and even the yen is seeing some significant

gains. So, to a large extend, we are talking more about the dollar’s weakness than we are about the euro’s strength. Now, from a European perspective, that provides some degree of comfort. It certainly means that European companies are losing competitiveness against US companies and against companies in the few countries that maintain links with the dollar. For Europe and many countries in Eastern Europe which are an important export market now for the Euro Zone, the strength of the euro is much less of a problem because many of those currencies are more closely linked to the Euro than the dollar. So, its strength is becoming an issue for the euro, but not as big as one might think. And, of course, it also has a positive effect, which is to help to break inflation. If the euro were to go much, much stronger it could become a problem. Around the current levels, it is consistent with a slowing, but not with a recession in the European economy.

Is there a chance that the European Central Bank might also cut interest rates?
Well, so far, the European Central Bank has its postponed rate hikes that it was proposing. It was doing that more in the response to the credit conditions than directly to the dollar strength. Now, we have begun to see the dollar looking so weak, our guess is that it certainly has the effect of postponing any likely European interest rate increases way into the future; and as for actual rate cuts in the Euro Zone - which a couple of months ago would have been almost an absurd suggestion - this is not very likely at this point, but also no longer absurd.

Let’s turn to bonds and equities. What’s happening there?
In government bonds we have seen the prices rising for shorter maturities. Not so for the longerdated maturities because people are beginning to be a bit more concerned about inflation. Our advice to investors is that it is those shorter-dated bonds - two to four years - which probably do offer the better value. With credits, investors have to be extremely cautious which credit is chosen. We have recommendations and advise clients to take account of these recommendations because there is a lot of uncertainty there. I would advise other investors also to seek expert advice. As for equity markets, of course, we are seeing a lot of short-term turbulence and we think that the reality is that volatility is going to continue. There will be days, maybe many days together, where we do see weakness in the markets. However, we still believe that - provided there is no recession, which we think is very unlikely to happen - equities still look good. Price earning ratios are not high. We remain constructive on equities and believe that investors should really be looking to these periods of weakness as an opportunity to add further to their equity holdings, although it is clearly a very volatile situation.

Recession is still a concern to some investors. Is there really no risk?
I wouldn’t go as far as to say there is no risk. But risk is still low. Obviously, we do have significant rocks in the road ahead and those include, of course, the credit problems and the current market turbulence. But we should be aware that company finances still look extremely strong, there is still a very strong growth momentum in emerging markets, particularly in Asia. We believe that the Fed and perhaps the other central banks - if they felt that the credit crisis was getting out of hand - would be able to notch rates down a bit more without triggering inflation. By the way, we have just been seeing more excellent productivity figures out of the US, which

adds to the sense that although we have high oil and food prices which temporarily push up the headline rate of inflation, the underlying rate does seem to be staying very well behaved because of that productivity, and because wages are not accelerating. So these are really good reasons why - although we have to be aware of risks - we feel that the risk of recession is really low.

So your overall take on the economy is still good?
Yes, our take on the economy is still good. Again, although we think the risk of recession is low, we do believe that the economy is slowing down. But that is normal. You get cycles in the economy where you have periods of faster growth and periods of slower growth. We have been through a very fast period earlier on this year through the end of September, which can be considered a very rapidly growing global economy. Now, as we move toward the end of the year and particularly into early 2008, we think that the global economy will be running at a somewhat slower pace. That’s actually a healthy development. It all fits with the idea that reduces the risk of inflation. But we do believe that the most likely scenario is that this is a relatively minor slowdown. In the bigger scale of things, as we move toward the end of next year, things will be speeding back up again.

So, how would you wrap this up for investors?
We are clearly passing through a period of heightened uncertainty which does mean there will be turbulence in markets, and in my view, we will have to live with high volatility for probably quite some time. Although that makes for a difficult investing environment, nevertheless, I do believe that investors should look through that to a bigger picture of the world economy, which looks as though it’s going to keep on growing. Therefore it is still a fundamentally healthy environment for equities and an environment in which shorter-dated and well chosen bonds can still play a role in portfolios.