Emerging markets will be the most important drivers of new global demand, helping to counterbalance the turmoil of stagnating developed economies. This is the verdict of the latest research from Barclays Wealth, which warns the US economy remains weak, while Japan is fragile and Europe is deteriorating amid dwindling growth forecasts. "In this context, the larger emerging markets are now a relative high point for the global economy," the Barclays Wealth Signpost May 2008 Monthly Update report states.
Emerging markets, most notably consumer goods exporters such as China, will be hit by a US slowdown as American consumers rein in their spending, but will nevertheless continue to grow this year and next. However, they won't be immune to a long-lasting slump or an outright recession, the report says.
The hydrocarbon economies of the UAE and other Gulf states are likely to face fewer problems arising from a long-debated US recession, thanks to strong domestic demand and stubbornly high oil prices. More than 90 per cent of new oil demand has come from other emerging economies, so slackening US consumption is unlikely to see oil prices fall dramatically, although most analysts believe the current price spike will soften soon.
This means the biggest danger to emerging markets is not weaker demand from trade partners, but soaring inflation, with annual inflation in the likes of the UAE and Qatar now estimated to have hit double figures.
Higher corporate earnings growth will enable emerging market equities to outperform their more established counterparts, Barclays Wealth report says.
This is an unsurprising conclusion, with the more dynamic, but riskier markets of Continental Asia and Middle East firmly on the radar of international fund managers.
Valuations have also come down this year, following a savage correction in the first quarter that saw some markets fall by up to 40 per cent. This has lowered 12-month forward price-to-earnings ratios from 16 to 12.
Investors appear to have more faith in the long-term stability in emerging markets than they did in the 1990s, with debt products no longer priced like high-yield bonds, the report says. But the global downturn has seen the pricing of risk aversion increase, albeit temporarily, by 100 per cent since summer 2007.
"However, this has now reversed… and the macro risk in emerging market countries is no larger than default risk in investment-grade companies," Barclays states.
Barclays Wealth is optimistic US authorities have limited a US downturn, claiming they "will win the war against the credit crunch", adding: "There has been a turnaround in markets and in market sentiment, and decisionmakers' approaches to policy problems have smacked less of desperation.
"Equity markets' recovery has occurred despite the continuing swathe of bad news on the US housing and labour markets, which has prompted many economists to trim US GDP growth forecasts further."
The resurgence of global equities – particularly those from the US – is a pleasant surprise, the report says, with investors seeing recent developments such as the rescue of US investment bank Bear Stearns as a "sea-change" in the credit crisis. The savage US interest rate cuts – benchmark rates have been slashed by 325 basis points since September – may have been risky, but have worked, it says, enabling American authorities to now concentrate on other policy shifts.
Consequently, Barclays Wealth has adopted a more hawkish stance, with the US Federal Reserve and the European Central Bank now under less pressure to cut rates further. However, the report still predicts a further 25 basis point cut in US interest rates this summer.
The upbeat messages from Barclays Wealth could fool readers into thinking US economic prospects are now rosy, but the report authors describe the near-term outlook for US growth as "dire", with house prices continuing their downward spiral and consumer confidence declining along with demand. Consequently, forecasts have been slashed, with the consensus "best guess" estimate for real US GDP growth now at 1.3 per cent, compared to 2.1 per cent in December and three per cent a year ago.
So with economists proving too optimistic in their previous forecasts, will the latest figures also be too high? Well, Barclays Wealth thinks as much, highlighting its own prediction for a 1.1 per cent increase in the US economy this year and a 60 per cent chance of recession. The latter figure means recession is more likely than not and the reality is the US has probably already entered a recession, although most commentators anticipate a minor upturn in the second half of 2008.
The report put it slightly different, saying six months of economic stagnation between October 2007 and March 2008 is the prelude of an upturn this quarter.
"The US economy has been slowing down dramatically since the second half of 2007. It is now close to – or already in – recession," the report says. "Real GDP will expand at about a two per cent annual rate during the second quarter and maintain that pace through the second half of the year," it adds.
In 2008, the US dollar and pound sterling have weakened markedly, while the euro, yen and Swiss franc have significantly appreciated, although these trends reversed over the past month. However, Barclays Wealth economists believe this is short-lived, with sterling continuing to fall, while the euro will remain strong and the US dollar weak, according to a Barclays report.
The latter prediction comes despite technical analysis indicating otherwise, with the dollar now below its long-run sustainable value. Usually this would mean it would be worth buying on a long-term – one year or more – basis.
But this ignores the current economic reality, with the hawkish European Central Bank seemingly loathed to cut rates, until the autumn at least, despite a slowing economy and the euro trading above its fair value. This suggests the dollar may edge lower against the euro.
"Although the dollar now looks cheap, we do not expect it to regain significant strength in the very short term," the report says.
"As we have previously stated, we would have to see some strength returning to the US economy, and the Federal Reserve drawing a line under interest rates, before we could justify a long position in the dollar."
For British expats, the good news is that sterling is likely to weaken further, despite mixed signals from technical analysis.
Indeed, Barclays' measure of fair value shows sterling is currently undervalued by six per cent. But the UK currency remains overpriced when using another tool calculating the value of sterling needed to balance the UK economy. Barclays' economists side with the latter opinion, predicting the pound has further to fall, in part propelled by further rate cuts by the Bank of England.