Best Economic and Financial Outlook

Macro and central bank outlook:

Global macro: The global growth cycle has peaked. So far, the slowdown has been led by the US and the UK, which have been mostly exposed to the credit crisis. During the year the weakness will spread to Europe and to some extent emerging markets. However, we still expect emerging markets to out-perform relative to developed economies. Consequently, the global central banks will begin to ease monetary policy, as rising concerns on growth will outweigh the inflationary risks from tight global commodity and labour markets.

US: The economy faces a tough ride in H1 as the financial crisis, rising energy prices and a continuation of the housing correction take a heavy toll on the economy. Although it is not our main case, recent data have highlighted the risks for a recession. Indeed, with growth forecasted to average only 0.75% AR during H1, the economy will be flirting with a recession early in the year. This leaves downside risks to growth as the predominant concern for the Fed, which we expect to cut interest rates by 25bp at each meeting during H1. This would take the Fed funds rate to 3.25% at the June meeting. In H2 the economy is expected to stabilise slightly below trend growth, as most of the current negative factors will ease off and monetary accommodation will gradually begin to take effect. The risk to our forecast is that the slowdown could prolong and become self-perpetuating, with the Fed easing more aggressively.

Euroland: Exports are set to lose momentum during 2008 as Eastern Europe and Russia are facing a slowdown, and as other traditional trading partners also continue to slow. Furthermore, consumers face substantial headwinds from falling real wages. Finally, investments will suffer from the slowing of exports and consumer demand as well as from the tightening of financing conditions. The risks of a hard landing have thus increased, and we now expect pressure to mount on the ECB to cut rates in September and December this year to take into account this risk. Uncertainty is larger than normal, and the ECB may prefer to remain sidelined if global growth does not ease much, and if underlying labour market dynamics are not hurt much. Also, should second-round effects materialise through strongly rising wage growth, this will definitely prevent the ECB from easing rates. In our view, the chances of the next rate move being a rate cut rather than a rate hike are 75/25.

Japan: Growth probably slowed markedly in Q4 on both weaker residential investment and private consumption. However, exports continue to perform strongly and industrial production has maintained momentum into 2008. Growth is expected to pick up in early 2008 due to a strong recovery in housing construction and stronger private consumption. Export growth will slow slightly during 2008 and the main risk to the Japanese economy is that export growth could slow more than expected during H2 08. Overall monetary conditions in Japan remain accommodative. The timing of the next interest hike will mainly be dependent on some signs of stabilisation in global growth. The Bank of Japan is expected to hike its leading O/N target rate by 25 bp to 0.75% in late Q4 08. Hence, the next rate hike in Japan has been postponed slightly from October/September.

Emerging market: Overall growth in emerging markets will slow slightly on both weaker export growth and domestic monetary tightening. Hence, while we expect the emerging markets to outperform the developed markets on growth, we do not expect the emerging markets to provide additional momentum to the global economy in 2008. In the emerging markets particularly Asia is expected to do well. However, Central and Eastern European growth is expected to slow fairly dramatically during 2008. Most at risk are the CEE countries with the largest imbalances . the Baltic states, Romania and Bulgaria.

Scandi macro: The macro story in Sweden and Norway will remain one of two very different economic outlooks. The Swedish economy is very exposed to the international economic downturn given its large dependence on exports and we will see a rather severe decline in Swedish growth in 2008. Inflation in Sweden is likely to undershoot the expectations of both market BEI rates and many analysts. The slowdown in growth is expected to pave the way for two rate cuts from the Riksbank in the second half of 2008. The international downturn will not pass unnoticed in Norway, but the Norwegian economy is far more shielded from a drop in international demand than Sweden or Euroland due to its exposure to oil. Moreover, the Norwegian economy is still in a state of overheating and we are facing real wage-driven inflation risks going forward. However, there are signs of weakness in the housing market. We may still see another rate hike from Norges Bank in Q2 to fight the overheating tendencies in the economy.

The Danish economy is expected to shift down a gear this year. We project GDP growth around 1.5% in 2008 and slightly less next year. The labour market is still at risk of overheating and thus a softening of domestic demand is welcome. House prices are expected to fall slightly in 2008 and this will dampen construction and private consumption, although consumption is supported by tax reductions in both 2008 and 2009. Exports are projected to grow modestly . constrained by higher than abroad wage growth and recent increases in the effective exchange rate. A referendum on the four EU opt-outs is expected late 2008 or early next year. However, it is not certain that a referendum on euro participation will be included. In the event of a euro referendum, the odds are that the Danes will vote in favour of participation, but as always it will be a close race. Participation will result in a narrowing of interest rate spreads.

The financial outlook is on the following pages.

Financial outlook

Equity markets:

It is typically difficult for the stock market, at this early stage of the slowdown, to differentiate between a sharp and long correction and mild short correction. This means, in our view, that the market at the moment is not able to predict whether the US and the global slowdown will be following a V shape or an L shape. The difference is that a V shape is an intra-year business in the sense that the downturn will be followed by a relatively quick recovery (The US recession of 1990-91 is a good example) while the L-shape will be an inter-year business, which in the worst case will evolve like the Japanese economy in the 1990s. The lack of transparency on the nature of the current US/global economic slowdown will be the greatest challenge for investors in H1 08.

We anticipate the stock market to price in the L-shape with a higher probability in the months to come. As described in the macro outlook section above, US GDP will move close to recession in H1 08, and as this occurs the stock market is at risk of falling through the 2007 lows. Our conclusion on the investment climate in H1 08 is that a US recession would be an overwhelmingly negative driver for the stock market.

We have recently revised down our medium term market level estimates. The key market where we hold a specific market target is the US. We have until recently had a three-month target for S&P500 of 1,550, but have revised down this target to 1,425 with a trading range of 1,350-1,500. On a 12-month horizon our S&P500 target is now 1,600, which is achieved mainly through valuation appreciation including P/E multiple expansion underpinned by a very low level of risk-free rates. For more details, please see Strategy Note: Investment themes in 2008.

Fixed income markets:

Global fixed income: Key features of our recent yield forecast are steeper and lower curves in EUR and USD out to the 6M horizon. Short rates are going to be pulled down by lower policy rates and the market.s tendency to extrapolate past policy rate movements into the future. Further, our expectations of elevated market volatility and fading risk appetite should support the current flight-to-quality bid into short government bonds.

At the longer end of the yield curve, we anticipate modest declines in 10Y government bond yields at the 6M horizon. Aggressive Fed cutting is going to push 10Y bond yields down. However, significant policy easing by the FOMC in the face of elevated inflation figures (we forecast roughly flat core inflation in USD and EUR) is going to limit the fall in long bond yields. From the 6M horizon and beyond, we expect EUR 10Y bonds to outperform their US counterparts as the ECB delivers 50bp cuts and the US economy stabilises.

The slope of the EUR curve has been lacking a clear trend in an environment of hawkish ECB communication and elevated spot inflation, on the one hand, and declining surveys and hard data on the other. Our forecasts for bond yields implies a steeper EUR curve as increasing expectations of ECB cuts will steepen up the curve. Strategy-wise we think risk-reward on steepener trades is better in Sweden, though, and would recommend implementing the steepener case there (see below).

In the US, the curve has steepened a lot recently. Curve steepening/flattening usually tends to display good momentum over long periods of time. However, over shorter periods of time, the recent period illustrates that the curve steepening has been far from smooth. In conjunction with the negative carry and roll down in 10-2Y steepeners, it is clear that timing is very important. The curve has recently been range-bound between FOMC cuts; much of the steepening occurred in a narrow window following each FOMC cut. The December meeting is an exception to this pattern, though, as strong retail sales and inflation figures postponed the steepening induced by the FOMC cut. Based on this need to manage steepeners tactically, we will consider taking on steepening exposure just ahead of the FOMC meeting on 31 January. Depending on market conditions, we may choose to express our market view by a highly correlated proxy offering better carry and roll properties, for example the 30-5Y swap slope.

In emerging markets there will be two main drivers of fixed income during 2008. First the inflation risks remain on the upside in emerging markets - this will make monetary easing hard in most EM economies despite looser monetary policy in the US and Euroland. Second, the outlook for rising global risk aversion will clearly be felt in the emerging markets' fixed income markets. Both factors are likely to weigh on the emerging markets fixed markets and we therefore in general expect EM yield spreads to widen vis-à-vis developed markets. This is likely to especially be the case in the Central and Eastern European markets where risk premiums are likely to rise further on the back of continued imbalances in the CEE economies.

Scandi fixed income: The story of 2008 for the Swedish and Norwegian fixed income markets will by and large be a continuation of our view that Swedish rates will outperform and Norwegian rates will underperform vis-à-vis EUR rates. The Riksbank will cut the rate by more than expected and Norges Bank is likely to stay on hold or even hike once more in 2008. In Sweden we also expect BEI rates to come down relative European BEI rates, and we believe 2008 will bring a greater differentiation between good and bad mortgage bonds. In Denmark, we anticipate two major themes; a tighter supply of both government and mortgage bonds and the possibility of a new EMU referendum. It is very uncertain whether the EMU referendum will take place, but it could be a factor working in favour of tighter swap spreads relative Euroland. The shrinking supply of Danish bonds is likely to tighten the government bond spread against Euroland

The trading positions to hold in Sweden, Norway and Denmark for 2008 will be:

A steeper 2-10yr SEK curve both outright and relative to the NOK curve

Receive (sell) 2009 dated SEK FRAs against EURIBOR futures or NOK FRAs

Pay 2yr NOK swap rates outright or against 2yr SEK (or EUR) swap and receive a great carry+rolldown on an ongoing basis

Go for a relatively lower Swedish BEI in index-linkers vis-à-vis French index-linkers (OATei)

Long Danish 2yr government bonds against Schatz

Receive 10yr DKK swaps against EUR swaps.

Credit: Re-pricing of credit risk has moved credit spreads to the current higher level and in 2008 we expect credit spreads to remain at these elevated levels. Our general view on Euro investment-grade credit is therefore neutral. From a relative value perspective we expect financials to outperform and thus have an overweight on the sector. However, in the shorter term supply pressure within financials may weigh on the sector. For corporates we expect increasing supply to come at a later stage partly forced by significantly tighter lending standards we have seen in the euro zone, the UK and the US. That said, investment-grade corporates are currently well capitalised following several years of high earnings growth.

Currency markets:

We continue to believe that dollar weakening has further to run, although increasingly we expect the multi-year increase in EUR/USD to be reversed around mid-2008. We target a rise to 1.52 within three months and do not rule out a peak around 1.55. However, the euro is unlikely to escape unharmed from the economic slowdown we predict, nor from the ECB rate cuts that we pencil in for the second half of the year. We look for EUR/USD to fall to 1.40 towards year-end. Our forecast assumes that the US economy does not enter into recession, as such an outcome is likely to weaken the dollar trajectory considerably.

We are increasingly confident in our forecast for USD/JPY to fall to 100 in the coming months. We have also lowered our forecast profile for EUR/JPY and expect a drop to 150 within six months.

We expect elevated volatility and fading risk-seeking to result in negative carry on a trend basis, at least in the first half of the year. Several currency pairs show unusually high correlations with equity markets currently, and a negative correction to global stock markets will tend to benefit JPY and CHF and weaken USD, AUD and NZD.

We look for EUR/NOK to fall further towards 7.75 in the coming months. We are less bullish on SEK, but do see a chance for a drop in EUR/SEK toward 9.30.

In Emerging Markets FX markets we could see increased volatility given the expected rise in global risk aversion and the continued global credit crunch. In general we would expect the "liquidity eaters" - countries with large funding needs - to underperform. This is especially the case for the Central and Eastern European countries. On the other hand the "liquidity provider" - countries with large FX reserves and current account surpluses - like most Emerging Asian countries, Russia and the Gulf States - to outperform. We expect the monetary authorities to move in the direction of more freely floating currencies in Asia, Russia and the Gulf States.

For more details on FX please see FX forecast update, 7 January 2008.

Commodities:

The weaker global outlook is expected to put a stop to the several year long rally in commodities. However, we certainly do not expect a collapse but a stabilisation in prices as emerging markets' growth continues to put a solid floor below prices. Furthermore, we have al ready seen a correction in base metals that are seen as the most business-sensitive commodities. Energy and agriculturals are also expected to be well supported by structural changes and investor interest in buying assets that give "insurance" against a weaker USD and higher inflation.

Danske Bank

http://www.danskebank.com/danskeresearch

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