Citigroup has just released the 2007 edition of its financial markets outlook report.

It predicts that the most likely scenario for global financial markets in 2007 is relatively benign. “Our base case envisions that interest rates in most major markets do not move much in 2007, the dollar gradually weakens, and equities in many markets perform well,” it says. “However, recent experience suggests that we should consider other possible outcomes for financial markets.”

The firm notes that risk premiums could fall further. It expects a number of near-term economic risks – the drag from U.S. housing, elevated core inflation – to dissipate over the course of 2007. Also, China and other countries are expected to continue to accumulate foreign exchange reserves thereby continuing to support global liquidity. “Under these circumstances, it is plausible that risk premiums could move lower still,” it says.

Alternatively, risk premiums could move back toward their historic norms, it allows, for a variety of reasons, including: monetary policy mistakes, supply shocks, and emerging protectionism. “The potential for a broad-based rise in risk premium is certainly a plausible concern, but more so over an extended horizon,” it says.

Citigroup expects the U.S. economy to return to trend growth by the middle of next year. “We think we are experiencing the most intense part of the correction in residential construction right now. Easing core inflation should give the Federal Reserve scope to cut short-term rates one time in the second quarter of next year. In the near-term long-term rates should also remain close to current levels,” it says. “Over a longer horizon, however, we expect the yield curve to steepen modestly with movement at both ends.”

For Canada, it predicts, 3% growth this year, sliding to 2.8% in 2007 and 2.4% in 2008. “Canadian economic activity is poised to ease back to a subpar pace near term, as slower U.S. growth caps exports. However, strong domestic demand fueled by healthy corporate profits and strong income growth, along with an improving exports outlook, should keep the Canadian economy on a near-potential track in 2007,” it says. “A maturing commodity cycle and a slowdown in housing activity likely will moderate the expansion to a 2.4% average pace in 2008, opening the door for a policy easing and a weaker Canadian dollar.”

“Core inflation likely will remain in the upper half of the Bank of Canada’s comfort zone throughout much of 2007 before moving back toward the target rate of 2.0% in late 2008,” it says.

“There are risks on both sides of the 2007 inflation outlook. A tight labor market, robust consumer spending, and an eventual fading in external restraints on Canadian inflation pose upside risks. Downside risks include a more protracted period of below-trend U.S. growth than we anticipate or a significant slowdown in Canadian business investment and hiring in the wake of soft global commodity prices,” it says. “Barring a dramatic shift in risks in either direction, we anticipate the Bank will remain on the sidelines in 2007.”

“In this environment, we remain constructive on the Canadian dollar near term, though normalizing global commodity supply trends and ebbing economic momentum could pose downside risks to the currency over longer horizons,” the report concludes.

Elsewhere in the world, it notes that growth in Japan has slowed somewhat in recent months. However, it believes that that the current weakness in some Japanese data is not fully reflective of the underlying strength of the economy.

Euro-area growth should slow in early 2007 in response to fiscal tightening in Germany and Italy, it predicts.
“There are hints that the euro-area economy may be more robust with domestic demand showing signs of resilience and productivity growth picking up modestly,” it says. “The ECB should raise rates again next month, but we do not look for any action after that for some time.”

It also expects China to accommodate somewhat more rapid currency appreciation in order to contain the growth of external surpluses. “Nonetheless China appears unlikely to take actions in the next couple of years that will reduce its external surplus substantially.”

The U.S. dollar should continue to drift lower on a trade-weighted basis, it adds.

Equities should outperform most other asset classes, the report predicts. “We expect earnings growth to slow, but profit margins remain high. Underlying growth expectations embedded in equity prices appear modest, leaving equities well positioned, particularly relative to other assets where valuations are more stretched.”