Strong share prices conceal unease about risk of setback

IF RISING share prices were reliable forecasters of economic recovery, recent trends have been reassuring. Compared with their October 2011 lows, equities were in bull market territory at the beginning of March 2012, with net increases of more than 20% in New York and many European markets.

But the predictive power of share prices is dubious. While one should acknowledge that some of the most acute economic threats have receded in recent months, any improvement in the situation is not yet soundly based. Risks of a setback later in the year remain serious. The critical factor driving the better mood of the financial markets was the European Central Bank’s (ECB) forceful action aimed at providing huge amounts of very cheap three-year money to the eurozone’s commercial banks.

The eurozone situation is still difficult and dangerous. Growth prospects remain weak, and may even be negative in 2012. Eurozone unemployment hit a record high of 10.7% in January. Nevertheless, the ECB’s successful initiative has considerably reduced risks of a banking crisis. A disorderly breakdown of the euro is most unlikely to occur this year. After making available €489bn (£409bn) in December, the ECB injected an additional €529bn at the end of February; it has also relaxed the collateral rules, in order to make possible a wider take-up of the money. The number of banks taking up the funds rose from 523 in the first instalment to 800 in the second, increasing the chance that some of the liquidity provided would percolate into the real economy, including small and medium-sized firms (SMEs).

So far, the flood of liquidity unleashed by the ECB has mainly been used to buy sovereign debt. The banks have also propped up their own capital positions. The impact on bonds has been dramatic, as ten-year Italian and Spanish yields dropped below 5%.

But the ECB’s successful operation has also generated controversy, mainly in Germany, where some argue that the commitment to low inflation is not sufficiently firm. Serious problems still persist. Spain was forced to raise its deficit targets in spite of objections from Germany and others, the Greek bailout plan is encountering difficulties, and there are fears that Portugal may need a new bailout. The basic point is that ample liquidity can ease short-term eurozone tensions, but it cannot resolve fundamental problems of solvency and lack of competitiveness in the periphery.

Unprecedented prediction

In the US, the recovery is still anaemic. The housing market is stabilising, with higher starts and building permits. But house prices still recorded a 4% year-on-year decline in December 2011, and this remains a major impediment for many heavily indebted households.

Other US figures are more positive. The labour market is improving, unemployment is down, and the economy is gradually strengthening. Annualised GDP growth for the fourth quarter of 2011 was revised up to 3%, from an earlier estimate of 2.8%, well above the 1.8% growth recorded in the third quarter and more than expected. But stronger US growth in the final months of last year was mostly due to much higher inventories, and this cannot continue indefinitely. For the recovery to be sustained, the US will need a stronger pace of expansion in consumer spending, investment and exports.

The Federal Reserve is reacting with caution to the economy’s improvement. But the markets were disappointed when Fed chairman Bernanke did not offer an explicit promise to embark on a further round of quantitative easing, known as QE3. Bernanke has not ruled out such a move. If the economy weakens, the Fed would not hesitate to launch QE3. But instead of focussing on the economy’s strengths, the markets are displaying a worrying appetite for new money. The Fed’s unprecedented prediction that official interest rates will stay at their current exceptionally low level of 0-0.25% at least until late 2014 is apparently not sufficient. This addiction to repeated injections of QE highlights the fragility of the current recovery. The markets are not yet confident that the upturn can be sustained without further life support from the Fed.

The UK, although not constrained by euro membership, has been unable so far to stage a meaningful recovery. The 0.2% GDP fall in the fourth quarter of 2011 was a disappointment, but it is unlikely we will have a new recession. The UK economy has probably returned to positive growth in the first quarter of 2012, but the pace of expansion will be very weak for two to three quarters. The expected fall in inflation will ease the squeeze on living standards and support demand. But the recent surge in oil prices, due to risks surrounding Iran, suggests that inflation will come down slower than expected. If oil prices increase much further, there will be worrying implications, both globally and for the UK.

As widely expected, UK quantitative easing was raised in February from £275bn to £325bn. This will strengthen the financial system, but the benefits of QE for the real economy have so far been modest. QE could be made more effective and helpful for businesses if the Monetary Policy Committee would be prepared, as part of the programme, to buy private sector assets, instead of focusing exclusively on gilts. It is critically important to improve the flow of credit to businesses, particularly viable SMEs. This means the urgent implementation of a substantive credit easing programme, and giving serious consideration to the creation of an SME bank. ?