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So what comes after Greece?

Blog by Bo Bejstrup Christensen, Chief Analyst at Danske Invest.

Looking back on 2015, Greece has been in all the headlines in the second quarter. Now, we hopefully have lift-off for an agreement to ensure Greece's future within the euro, as well as the country's economic survival. So it's time so start taking a look at life after Greece.

In rough terms, we believe that three key topics will affect the second half of 2015. Our overall message is that we still expect growth in the global economy and thereby positive returns on the most risk-prone assets, including global equities. But there will be bumps in the road, with major regional differences.

Starting with the US, the world's largest economy, we believe that at the end of the second quarter growth is back at 3 per cent. Due to the Greek crisis, this has more or less been overlooked.

For us, the vital aspect is that we expect this growth rate to be maintained, i.e. that the economy will deliver growth of around 3 per cent in the second half-year. The two primary contributors are a continuing sound banking system, which supports the private sector, and normalisation of the constrained housing market.

If our expectations prove to be correct, this is a significantly more positive growth scenario than the American Federal Reserve currently has in mind. During the past weeks, leading members of the Federal Reserve have furthermore stated that growth of around 2.5 per cent is okay, and that the economy's long-term potential – what we call trend growth – is close to 2 per cent.

This means that the economy is currently absorbing the available resources, which naturally includes the empty hands in the job market. The Federal Reserve is thereby approaching one of its goals, which is full employment.

Interest rate hike in September
The fact that any tightening of monetary policy only has an effect after a certain time lag is in itself an argument for the Federal Reserve to begin to raise interest rates. If our expectations of 3 per cent growth prove to be correct, the labour market is stronger than the Fed expects, and thereby also strong enough for the first interest rate increase to be seen within the foreseeable future. Our best expectation is that it will come in September.

An interest rate increase in September is not currently priced into the fixed income market, which means that after Greece we can expect significant fluctuations in the American debt securities markets. This in itself is the best argument for the Federal Reserve to wait a little, so as not to surprise the market too much.

Our primary argument here is that the Federal Reserve has signalled clearly that it depends strongly on economic data. Our assessment is that data will be on the strong side, so that, when we reach September, the market will more or less already have priced in the first interest rate increase.

So the second half-year will see rising American interest rates. In the first instance, the equities market will struggle a little with the rising interest rates, but ultimately, the sound growth will set a limit to how far shares can fall, and in time will push them up further. Finally, this should also lead to the US dollar gaining more ground against most currencies. This scenario should be a positive cocktail for Japan, where exports benefit from both high American growth and a weaker currency. There is also sharper focus on companies' profitability.

Growth in Europe will recede to 2 per cent
Turning towards Europe, our primary message for the second half-year is that growth will be declining. While Greece has monopolised the headlines, European growth has reached around 2.5 per cent, which is more than double the region's long-term potential.

Some of the shortlived factors pushing up growth include the lower oil price and strongly weakened euro. We believe that the positive effects of this are peaking now. Even though we expect that a solution for Greece will initially give a positive mood, we believe that growth will decline from around 2.5 per cent to 2 per cent.

Why will growth be around 2 per cent? For the simple reason that the European banking system is on a sound course and thereby able to lend to the private sector. This is something that the region, especially the crisis-stricken countries, has lacked for close to five years.

We should therefore see growing investments and a renewed willingness to hire new staff. Two per cent growth in Europe is good, but the context is that we have undergone a prolonged crisis, with very high unemployment. We therefore believe that there is little immediate prospect of inflation returning to the Eurozone. This also implies that the European Central Bank will find it hard to achieve its target of 2 per cent inflation within the next few years.

So even though growth will be favourable, and together with less uncertainty regarding Greece should lead to higher European share prices, in contrast to the situation in the US we do not believe that European interest rates – including Danish rates – must increase significantly in the short term. Rather, we expect that they will be stable, or slightly rising.

Continuation of the exceptionally expansionary monetary policy in Europe will thus be highly evident, especially in relation to the US, so that we expect the euro in particular to weaken against the dollar.

Will the authorities accept lower growth in China?
Finally, the current plummeting prices in the Chinese equities markets are hitting the headlines – which we believe is stealing attention from what really matters. Mainland Chinese equities are in a league of their own and any decrease in them will not compromise financial stability, because the authorities wish to ensure stability in the banking system.

On the contrary, our focus is on the impact on economic growth. Our assessment right now is that growth increased in the second quarter from a very low level in the first quarter and is now at a level of around 6-6.5 per cent.

In future, we assess the key issue to be whether the authorities can and will accept growth at this low level. Or whether – as before – they will seek to stimulate it further, in order to push it even further up. We believe they will go for the first option.

Why? This may seem rather hard to understand now, when the government is still, sometimes, talking about ensuring growth over 7 per cent. In our view, the response to this question is hidden in the fact that, even for the Chinese authorities, it can be hard to find out what is actually going on in the Chinese economy right now.

In 2014, their objective was to deliver growth in excess of 7 per cent, creating 10 million new jobs. Growth was generally as expected, but the economy actually created 13 million jobs. We are now getting more jobs for the same growth rate, which in our view is due to major significant changes in the underlying structure of the Chinese economy, where the service sector accounts for an ever-increasing share of the economy. The service sector creates more jobs than the traditional industry and construction sectors, so that even if the economy "only" grows by 6 per cent, this should be more than enough to create sufficient jobs to facilitate social stability. Just as important is that we believe that the authorities will not repeat the errors of previous times, i.e. overstimulating the construction and housing sector.

Toxic cocktail for new markets
So the good news is that China continues to grow. The bad news is that this is a different type of growth to what we have been accustomed to. It is far less dependent on raw materials, which in turn creates problems for a number of countries in the new markets, which depend on raw materials exports.

If we are right about this scenario, simultaneously with the Federal Reserve's raising of interest rates, this is a toxic cocktail for the new markets. Interest rates in the new markets will be subject to upward pressure, driven by rising US interest rates, resulting in lower bond prices.

Exchange rates will be under pressure, especially in the countries that depend on external financing. Finally, shares will also be under pressure, since they are already battling with relatively low trading growth at a time when their financing costs can potentially increase.

Therefore, once again, we are emphasising our motto of the last couple of years that a cautious approach should be taken to investing in the new markets. Also, we can no longer speak of the region as one homogeneous entity, but rather a collection of very different countries, of which most will face tough times in the scenario we are depicting for the world. Therefore it is also necessary to be selective.

So how does the world look after Greece? Fundamentally, it is looking good. The global economy is continuing to grow, led by especially the US and Europe. Monetary policy will still be expansionary, although the Americans are taking the first steps towards a more normal monetary policy. In overall terms, this is a positive scenario for risk-prone equities, including global equities, but first of all in Europe and Japan.

Hold tight out there, and stay tuned to my blog.
 

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