Growth is likely to be slow but steady

Investor's Guide to the Market: The final week of August brought some cheer to equity investors as most stock market indices staged a recovery from the summer doldrums.

For example, the FTSE Eurotop300 had its best week in about five months with a weekly gain of 3.2 per cent.

However, these across-the-board share-price gains occurred in the context of very light holiday trading volumes. The early weeks of September could well see a sharp pick-up in trading activity in line with normal seasonal trends.

However, trading volumes could expand more sharply than the norm depending on the trends that emerge from the welter of data releases due this month.

Current debate regarding the future direction of the global economy is more intense than usual after a summer of rising oil prices and a number of disappointing economic data releases. As a result, there has been growing support for the view that economic growth may slow sharply in the second half of the year.

The key arguments in support of an imminent slowdown are threefold:

With regard to oil prices, economists use as a rough guide the calculation that a sustained $5-per-barrel rise in the oil price subtracts about 0.3 percentage points from global growth in the following year.

If oil prices were to sustain the recent peak of $49 per barrel, it would shave at least one point off global growth in 2005. It is therefore not surprising that market participants are breathing a huge sigh of relief in light of the recent pullback in the oil price.

A tightening supply/demand balance and a sharp increase in the risk premium, mainly due to the Iraq conflict, has driven the sustained rise in oil prices over the past two years.

It is impossible to estimate the relative importance of each of these factors. However, it does seem that the rapid rise in the oil price from $40 to $49 per barrel was due primarily to a rise in the risk premium and associated speculative trading.

The very rapid pullback in the price to the low $40s is testament to this. The oil market seems set to be characterised by very high volatility for a prolonged period, which makes forecasting oil prices an extremely hazardous proposition.

On balance, it is unlikely that oil prices will rise high enough to abort the global economic recovery. Rather, pressure in the oil markets will merely serve to put a dampener on such growth prospects.

Weak consumer demand is the second factor that is causing economists to question the durability of global expansion.

Weak US employment reports over the summer have led some analysts to forecast a fall-off in consumption in the second half of the year.

Alan Greenspan, chairman of the US Federal Reserve, has repeatedly expressed the view that the US economy is currently going through a "soft spot" and that the pace of activity will reaccelerate in the second half of the year. The economic data to be released in September will help to resolve this debate, with labour-market data taking centre stage.

Evidence of a resurgence in consumer demand across Europe remains elusive, although there has been a modest improvement in France and to a lesser degree in Germany.

In Britain, the Bank of England seems confident that its policy of gradually raising interest rates is cooling the economy without suffocating consumer demand and the recovery in manufacturing.

Overall, a continued slow but steady recovery in investment and consumption still seems to be the most likely outcome in Europe over the second half of the year.

The growing importance of Asia in influencing global economic trends is a factor that is now beginning to take centre stage. The region's two largest economies, China and Japan, experienced a slowdown in the second quarter.

In Japan, the government recently announced that annualised GDP growth slowed down to an annualised 1.7 per cent rate for April to June. However, several forecasters view this as a blip and expect that the underlying annual growth of 3 to 4 per cent will be maintained.

There is a greater diversity of opinion regarding the Chinese economy, which officially grew by an annualised 9.8 per cent in the first half of the year. Such growth is unsustainable and the authorities are trying to engineer a soft landing.

A hard landing in China is probably the single greatest threat to the global economy going into 2005. The consensus view is that a soft landing will be achieved, thus maintaining China's positive impact on the global economy.

By now, equity markets should have discounted most of the above risks to the global expansion, and therefore if current and upcoming economic data supports the benign view of an ongoing recovery, share prices should respond positively.