THE NEW Year started on an optimistic note. After a dismal ending to 2011, the financial markets reacted with relief to renewed hopes that the much-feared collapse of the euro is not imminent. But sharp temporary rises in share prices, and related increases in risk appetite, do not signal an end to the economic crisis or a fundamental improvement in prospects.
At best, recent events offer hope that the worst fears will not materialise. The risk is that we have witnessed an over-reaction to a few items of good news, while underlying global threats persist and may well worsen later in the year.
The purchasing manager indices (PMI) for January were better than expected in most major economies – the US, China, the eurozone and the UK. Both manufacturing and services improved. Economies that were formerly in negative territory returned to positive growth. In the US, the PMI survey data was backed by stronger GDP growth and, more significantly, by much better-than-expected job figures.
However, the major factor that transformed the markets’ mood was the European Central Bank’s (ECB) decision to offer commercial banks huge amounts of very cheap three-year money. Almost €500bn (£414.8bn) was provided already, and the amount made available is likely to be doubled in the next few weeks. Since German opposition prevented the ECB from purchasing directly sovereign paper, the massive liquidity has enabled the commercial banks to buy eurozone government bonds, and this has played a key role in stabilising the markets and in producing sharp falls in the borrowing costs of Spain and Italy.
Risks of a eurozone banking crisis have eased. But even a virtually limitless injection of liquidity cannot resolve deep-seated problems of solvency and lack of competitiveness in the eurozone’s periphery, which will continue to pose serious threats to the survival of the euro.
The negotiations on the “haircut” that private sector holders of Greek sovereign debt will have to accept are still on a knife’s edge. An agreement will not necessarily prevent an eventual Greek default.
The rating agencies are not infallible and they certainly deserve the flak they are often getting. But many of the messages they convey are credible and necessary. It is difficult to fault Standard & Poor’s recent decision to downgrade the credit ratings of nine eurozone members. Most dramatically, France, Austria and the EFSF (the eurozone bailout fund) all lost their triple-A ratings. France was particularly displeased with its diminished status, but the demotion reflected objective factors that cannot be shrugged off. Portugal’s rating has been cut to below investment grade, and the country is now classified as “junk”, together with Greece. Pressures on Portugal have inevitably worsened after the downgrade, and risks of default would escalate if growth does not revive.
The fact that only four eurozone members are still rated AAA (Germany, the Netherlands, Finland and Luxembourg) provides a timely reminder that new debt crises can be realistically expected to erupt later in 2012. Though some of the eurozone gloom has lifted slightly, the economy is still very fragile, with unemployment rising in December to a new record high of 10.4%.
The jobless figures confirm the weakness of any recovery, and highlight again acute divergences between the relatively strong core and the feeble periphery; this will remain a debilitating factor for the eurozone, as Spain’s jobless rate surged to 22.9%. In the face of these challenges, we expect the ECB to cut its key rate from 1% to 0.75% in the next few months, and to continue pumping liquidity into the banking system. The ECB is now more successful in circumventing the restrictions imposed on it, and rates are unlikely to be raised at least until Q2 2013. While risks of the euro disintegrating in 2012 have lessened, longer-term dangers will persist. It is still realistic to expect a radical restructuring of the eurozone in the second half of 2013 or in 2014, after the 2013 German general election.
Developments in the US have been even more positive than in Europe, but one should not exaggerate the good news. The US created 243,000 new jobs in January, more than analysts’ expectations of about 140,000, and the biggest monthly increase for almost a year. The US unemployment rate fell from 8.5% to 8.3%, the lowest figure in almost three years. But the recovery in the US jobs market is still mediocre by historical standards. The housing market remains weak. In November, US house prices fell 1.3% on the month and 3.7% on the year. With foreclosures remaining high, house prices are still facing downward pressures. The Federal Reserve has not yet decided to increase quantitative easing (QE) further, but it remains concerned about growth and is now predicting that official interest rates will stay at their current exceptionally low level of 0-0.25% at least until late 2014. This is not a legal commitment, but the markets interpreted the Fed’s move as a significant easing in US monetary policy.
In the UK, disappointing GDP figures showing a 0.2% fall in the fourth quarter of 2011 have heightened fears that the economy may slide again into recession. The gloomy reaction to the GDP figures was partially lifted by better-than-expected PMI indices for January, indicating a return to positive growth in the first quarter of 2012. But the Monetary Policy Commission still appears set to increase its QE programme, initially by at least £50bn. Official UK interest rates are likely to stay at 0.5% at least until Q2 2013. ?