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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(November 13, 1997) CURRENCIES: Continuing our theme which warns of the danger that slowing world growth could, if policies are not appropriate, turn to world recession, we now turn to Europe. A week ago, the Bank of England raised rates 25 basis points, indicating, that where warranted, countries are willing to boost rates despite the developing Asian crisis and its potential for slow world growth. Meanwhile, the Bundesbank has raised rates 30 basis points while the German administration has frozen government spending as tax revenues fall below expectations.
The distinction between the policies of the UK, on the one hand, and Germany, on the other, is a good example of the notion that, for some countries such as the U.S. and the UK somewhat restrictive policies may be appropriate, while for others such as Japan and Germany the same policies may be inappropriate. In the case of the UK growth is expected to run at 3.7% this year and 3.3% next year while unemployment is expected to fall from 6.7% at the end of 1996 to about 5% at the end of 1997. Meanwhile measured inflation has risen from 2.5% yoy at the end of 1996 to 3.6% yoy at the end of September, and could rise further if the economy does not slow. As with the U.S. the rise in the currency will offset some of the price pressures, and in the case of the U.K. which is more dependent on trade, the impact could be more disinflationary than in the U.S. While the economy is still robust the impact of rising rates and a strong currency will slow growth going forward, perhaps more so than might have been the case prior to the Asian development.
In contrast, Germany has virtually no domestic growth and an 11.2% unemployment rate. While growth is expected to be 2.5% this year and rise to 3.3% in 1998, to date the growth has not been sufficient to make a dent in unemployment, and to the extent that it is based on export growth is, in effect, taking its growth from potential production elsewhere.
Perhaps the biggest single factor which hurts tax revenue growth in Germany is inadequate demand. Whereas the U.S. has been in a virtuous cycle in which growth is boosting tax revenues and cutting social expenditures and thus taking the budget deficit lower, Germany in contrast has not been able to meet its deficit reduction targets despite enacting more substantial fiscal cutbacks than the U.S. We submit the reason is that the Bundesbank, in contrast to the Fed, has undermined the process by not fully offsetting the attempts to consolidate fiscally through more aggressive rate reductions. Now, its attempts to raise rates at a time when the government is still cutting spending threaten to reverse a still shaky recovery. If this happens at a time when Asian growth is slowing and the U.S. and UK are slowing their own growth, the result could be much slower world growth in 1998 than is currently being forecasted.
As far as currencies are concerned, the longer-term impact of the BOE's rate hikes will be to slow the UK economy and potentially put downward pressure on the currency as rates fall. However, the near-term impact will likely be to boost the pound especially since the rate rises are consistent with domestic policy needs. In contrast, the Bundesbank may have to reverse its rate rises sooner, and if the economy slows down, its currency is vulnerable. Thus, the pound is likely to rise relative to the mark over the intermediate term.
Specifically we see the pound rallying back to its July high in the 3.02 to 3.05 range, and possibly beyond that level. The recent 2.8 corrective low in September will likely be the bottom of the range and we do not anticipate much of a retest of that low. Against the dollar. we think the pound will likely stay in the 1.68 to 1.74 range. If the mark falls back as we forecast, this will tend to keep a lid on the pound against the dollar.
Frankly, the mark has been stronger than we earlier forecast. However, our sense of the fundamentals continues to lead us to conclude that the mark will retest the 1.80 to 1.85 area over the next few months. If it does move above the top of our intermediate-term range of .5500 to .5900 we think the move will be temporary and will represent an intermediate selling opportunity. Despite the recent rally and technicals which urge caution for the short, the mark is near the top of the range we think is consistent with the fundamentals.
(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
David Horner
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