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The Markets in 2007

The outlook for 2007 is dominated by the slowing US economy. With the US getting a cold, fund managers are contemplating whether the rest of the world will start sneezing, or will manage to stay warm.

In the last year the US has seen a definite slowing of economic activity, with a cooling housing market, off the back of 17 successive interest rate rises from the US federal reserve, and rising oil prices both hitting consumer spending. This slowdown has prompted fears that the rest of the world could see a slowdown.

While the US economy could well be looking slightly more favourably into 2007, the rest of the world is an open book.

Andrew Milligan, head of Global Strategy [Report], foresees 2007 dominated by the slowdown in the US economy with a moderate slowdown in the US economy over the coming quarters, bottoming out in spring 2007.

He said: "The rationale is the squeeze on consumer disposable incomes from two sources, the rise in energy costs, with gasoline for example almost back up to its level after Hurricane Katrina, and the rise in debt servicing costs, in particular the rise in mortgage rates."

He points to current moderation in retail spending, and a deceleration in the housing market. However, he predicts a slowdown closer to that of 1995, rather than the recession experienced in 2002.

The view on the world economy is upbeat with growing potential seen in Japan, an upturn in European industrial production and increasing demand in the Middle East, Russia and Asia.

Meanwhile Barings World Monthly Review [Report] predicts that the US housing slowdown could take one per cent of economic growth next year. In the UK the manufacturing sector is described as "shaky".

Looking into Europe, John Cummins head of treasury at Standard Life Investments [Report] regards 2006 as a strong year for the Eurozone economies, with retail sales above expectation in the first part of the year, improved employment figures and the highest producer price input numbers in over five years.

Looking forward he sees slower growth in the US, with higher interest rates in Europe and Japan not greatly holding back economies.

Threadneedle chief investment officer Sarah Arkle [Report] writes: "In Europe export growth is buoyant, particularly to Asia, implying that the effect of any slowdown in the US will be less than in previous periods. Japan seems to have seen slightly weaker consumption during Q3 but activity has picked up since.

"In general we see global growth, excluding the US, being fairly resilient as long as the US slowdown does not become a hard landing."

She adds: "We have recently revised up our earnings forecast for the US for both this year and next and now see better value in that market than previously."

The weakening housing market, which could translate into job losses, and looming production cuts from the big three US auto manufacturers, are balanced against falling US petrol prices and solid personal income growth that should keep the US economy on the road.

The forecast is for US GDP to end 2007 up by 2.75 per cent, compared with the 2006 projection of up 3.4 per cent.

In the UK, over the last year fears of the US slowdown spreading across the Atlantic have not been founded. UK house prices have remained buoyant, consumer spending steady and manufacturing performance has improved.

In the coming year strong housing market is expected to generate growth, while the fears that high oil prices and utility bills would bite heavily into the economy were exaggerated.

"On the other side of this coin, unemployment creeps higher and wages are being held in check by the UK's openness to east European migrant workers. We think the MPC has overstated the case for inflation risk," adds Mrs Arkle.

In the equities market the UK market's performance is expected to continue benefiting from the strength of corporate balance sheets and the sustainability of the earnings cycle, boosted by greater stability in commodity prices and ongoing M&A activity.

Edmund Brandt, investment director at JPMorgan Asset Management [Report], claims the picture in Europe will not be as rosy as some predict.

He writes: "Disappointing economic news, including the announcement that the French economy had stagnated in the third quarter, did raise questions over the sustainability of Europe's economic recovery, particularly if interest rates continue to rise over the next six months."

In the US he also points to a narrowing of the US trade deficit to $64.3 billion and comments from the president of the Chicago Federal Bank that the US economy should bounce back from weaknesses reported in the third quarter of this year.

The US is currently showing a mixed picture, with manufacturing contracting and hitting its lowest level since April 2003, according to the Institute for Supply Management.

However, auto sales have picked up with General Motors, Chrysler and Toyota all reporting increased sales, although Ford next year will reduce first quarter production by 14 per cent.

One element that could cast a shadow over eurozone performance will be the increase to German sales tax in January. The European Commission sees growth in the eurozone of 0.6 per cent in the first half of the year and 0.5 per cent in the second half.

Unemployment is expected to fall in Germany, but the prospect of the European Central Bank upping interest rates to hold back inflation coupled with the German tax could rein in growth.

Trevor Greetham, Asset Allocation Director at Fidelity International, sees 2006 as a year of transition with emerging-market equities and commodities generating strong returns while bonds struggled.

Looking to 2007 he writes: "I believe that a back drop of slower global growth and falling inflation favours global bonds overstocks and commodities. It also favours the more defensive developed markets over Asian and emerging-market equities. In global sector terms, I believe interest rate-sensitive consumer stocks and financials will fair better than cyclical industrial and technology sectors."

Mr Greetham predicts that Japan over any other country is most likely to suffer from the US slowdown with the UK stocks remaining defensive.

David Urch Investment Director at SWIP and manager of UK SWIP Opportunities Fund [Report] foresees UK equities continuing to offer attractive value "with both corporate earnings and dividends growing strongly in a number of sectors".

He added: "Corporate activity remains a prevalent theme and provides further support to equity valuations."

Looking back over 2006, the year was dominated by interest rate rises across the globe taking on inflation while oil price rises hit growth and spending. Looking forward, while interest rates may continue to increase, the battle against inflation is expected to be largely won for the time being. The outlook for most major economies is growth, but not overly strong growth, with US consumers keeping their spending cool.