THE MARKETS’ continued buoyancy, in the face of mediocre economic prospects, has pushed share prices to new multi-year highs. But the strong risk appetite is difficult to justify in the face of slowing global growth and heightened financial risks. The financial markets remain too addicted to increasing doses of cheap money. As long as the major central banks are prepared to maintain an open tap for a prolonged period, a degree of complacent exuberance will persist.
But there are signs that much-needed caution is returning. It is too early to predict a major downward correction, but equities and other risky assets are too expensive. After the US November election, policy makers will have to face unpalatable choices. The markets will have to adapt to new risks.
The very existence of European Central Bank president Mario Draghi’s “bazooka”, officially known as Outright Monetary Transactions (OMT), has eased eurozone tensions, and has kept Spanish and Italian sovereign bond yields at levels well below earlier highs. But the scheme has hardly been used. The ECB can activate the scheme only if governments apply for, and accept, the harsh austerity terms of a bailout. But there is strong opposition, particularly in Spain, to a formal bailout request, which many see as a national humiliation.
Draghi is urging governments to apply. But by driving down yields, OMT makes governments less inclined to ask for help. The ambivalent German attitude to OMT – with chancellor Angela Merkel reluctantly supportive and the Bundesbank strongly opposed – is a threat. The Bundesbank is respected, and German politicians cannot indefinitely shrug off its scepticism.
The eurozone economy is deteriorating. The September PMI (purchasing managers indices) signal a return to recession in the third quarter of 2012. Growth forecasts have been reduced, and unemployment rose to a record high of 18.2 million in August, while the jobless rate stayed at a peak of 11.4%.
Huge divergences between core and periphery remain a source of tension. High youth unemployment, which is above 50% in Spain and Greece, could become politically explosive. In spite of OMT, there are serious risks that a Greek crisis will erupt again. The view that the euro is now secure is too complacent. The ECB’s position remains pivotal. By launching OMT, and by supporting moves towards a banking union, the ECB has pushed core members (e.g. Germany, the Netherlands and Finland) to accept, albeit grudgingly and by stealth, moves entailing more burden sharing. These steps are critical to the euro’s survival.
But there is no explicit agreement in support of such policies. Many strongly oppose burden sharing, on the grounds that it is both illegal and immoral, and will cause higher inflation in the future. As the September 2013 German election draws nearer, the controversy will intensify. With eurozone consumer inflation increasing to 2.7% in September, well above the official target, and in the face of Bundesbank opposition to OMT, the October ECB meeting left official interest rates unchanged. But, with risks of the recession worsening, we expect a cut in the key ECB policy rate in the next few months, from 0.75 to 0.5%.
The US economy, though stronger than the eurozone, is still too weak. Second-quarter GDP annualised growth was revised down to 1.3%, unacceptably low. But house prices rose in July for the third month in a row. The housing crisis is slowly ending, thus removing a major obstacle to a durable US recovery. The labour market is also improving. 114,000 new jobs were created in September, better than expected. The unemployment rate fell to 7.8%, its lowest point since Barack Obama took office in 2009. But it is premature to conclude that the job figures will affect the election result.
The Federal Reserve remains worried; it launched an unprecedented open-ended version of quantitative easing (QE3), by purchasing, each month, an extra $40bn (£25bn) of mortgage-backed securities. There is no upper limit. Asset purchases will continue until the job market improves. While QE3 will increase demand for risky assets, its ability to boost growth is questionable. There are also risks that cannot be ignored: financial distortions, bubbles and future inflation. Trade tensions could escalate, as QE3 is seen as a US attempt to secure a competitive devaluation.
After the November US election, the markets will focus on the “fiscal cliff”. Unless Congress acts, $600bn of tax increases and spending cuts will come into effect early in 2013, threatening a new recession. If political impasse blocks agreement on a new debt ceiling, the US government may become paralysed, resulting in a new credit rating downgrade. One hopes that the politicians will draw back from the brink. But if US uncertainties coincide with a new euro crisis, we could see a major market correction and a panic flight to safe assets.
The UK prolonged stagnation is increasing pressures for a new dose of QE before the end of the year. But it is doubtful if this will benefit the real economy. Figures due in October will confirm that GDP returned to positive growth in the third quarter. But, since a working day was lost in June due to the Diamond Jubilee, a bounce-back in the third quarter is not yet proof of sustained recovery. The government has accepted demands from business for new growth-boosting measures. But room for manoeuvre is limited, since Britain’s fiscal deficit in the current financial year will probably exceed the forecasts made at the time of the March Budget by more than £20bn. Implementing the government’s deficit-cutting plan will take two to three years longer to complete than envisaged last March – but the job is feasible.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest group chief economist