Macro View: Exuberant markets continue to defy mounting threats

IN spite of serious risks, the global financial markets remain surprisingly exuberant. While there has been recurring nervousness, many stock markets have risen to new highs.

Since global growth prospects are mediocre at best, objective factors cannot easily justify this optimism. Escalating geopolitical tensions relating to Ukraine and Islamic State (IS) are highlighting exceptional dangers, particularly for the eurozone. An ongoing conflict potentially involving Russia and the possible redrawing of borders in Syria and Iraq entail threats that cannot be shrugged off. Even if the fighting in Europe can be contained, the imposition of sanctions on Russia will have adverse consequences.

Government bonds, where yields have fallen to record lows, are conveying a more sombre message than the equity markets. Though some central banks are now considering the timing of an interest increase, probably in 2015, most policy makers are still focusing on inadequate growth and on the risks of deflation, or at least unduly low inflation.

The eurozone remains the weakest and most vulnerable global region, and a stimulatory move on the part of the European Central Bank (ECB) has been widely expected for some time. But the ECB still shocked the markets when it announced early in September that it cut its official interest rate from an exceptionally low level of 0.15%, to a new record low of 0.05%. The ECB also moved its deposit rate further into negative territory, by cutting it from minus 0.1% to minus 0.2%. By charging banks a bigger penalty for parking their deposits with the central bank, the ECB’s aim is to encourage lending.

Most radically, the ECB launched a programme of private-sector asset purchases, helping to trigger a sharp fall in the euro against the US dollar. But it is by no means clear that the ECB’s dramatic move will have the desired result of stimulating growth, even if it succeeds in halting the fall in inflation.

The eurozone’s dire economic situation was the key trigger persuading the ECB to abandon its reluctance to buy assets. GDP recorded zero growth in the second quarter of 2014, worse than expected. In the past year, the eurozone economy grew by a minimal 0.7%, well below annual growth of 3.2% in the UK and 2.4% in the US. Germany, the largest and most powerful eurozone economy, fell in the second quarter. Italy, the third-largest economy, entered its third recession since 2008. France, the second-biggest economy, failed to grow at all and was forced to admit that it would miss its 2014 budget deficit target.

Eurozone annual inflation fell to 0.3% in August, a five-year low. Heavily indebted southern European economies are facing deflation. The jobless rate stayed high, at 11.5%. In some countries, unemployment rates are well above 20%. Given this grim background, the ECB was forced to act. But its move was controversial. There are fierce arguments over the likely effectiveness, and the meaning, of the ECB’s decision.

In line with Germany’s opposition to monetary activism aimed at raising inflation, Bundesbank president Jens Weidmann opposed the move. However, some argue that the ECB is still not engaging in outright QE. Unlike other central banks (eg, the Bank of England) that are mostly buying government bonds, the ECB’s purchases are restricted to private sector assets. But this is a technical quibble and there can be no doubt that we saw a major policy departure.

The initial results are likely to disappoint, because official rates have already been near zero, and the scale of the asset purchases will be limited. But economic weakness will lead to pressures on the ECB to expand the programme, and this will heighten German wariness. The eurozone will face an unpleasant combination of poor economic performance and escalating tensions, leading to policy paralysis. Our GDP growth forecast for 2014 is being downgraded to 0.9%

Upward revisions

US economic performance remains consistently stronger than that of the eurozone. But the US record is mediocre by historical standards, and recent trends have been mixed. On the positive side, second-quarter GDP growth has been revised up to an annualised rate of 4.2%. Our 2014 US growth forecast is being upgraded to 2%. While still relatively low for this stage of the recovery, our new forecast is an improvement on what was expected only a few months ago.

However, the labour market has suffered a setback. The US economy created only 142,000 new jobs in August, fewer than the expected 230,000. The unemployment rate fell slightly to 6.1% in August, but this was because more discouraged workers did not seek employment. There are also signs that the US housing market is cooling, as price rises slow. The National Home Price Index rose by only 6.2% in the 12 months to June 2014, in sharp contrast to the double-digit year-on-year increases common in 2013 and the first part of this year.

The housing and job market figures suggest the US recovery is losing momentum, in spite of strong GDP numbers. This will make it easier for Federal Reserve chairwoman Janet Yellen to resist pressures for early rate hikes when the tapering of the asset purchase programme ends. We expect US official interest rates to remain at their current low level of 0-0.25% for at least six months. The first increase in the Fed funds rate is still most likely to occur in the second quarter of 2015.

The UK continues to enjoy stronger growth than all other major economies. But the clamour for an early interest rate increase is intensifying. The minutes of the August MPC meeting reveal that two out of nine members voted for an immediate rise in rates. But tightening UK monetary policy too early would be premature and potentially damaging. With wage pressures still very weak, and inflation below target, the MPC can afford to wait until next year before raising rates. In the face of stagnation in the eurozone, and mounting political uncertainties relating to the Scottish referendum and the 2015 general election, the economy needs a period of stability. It is unwise to put the UK recovery at risk.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist