AFTER ENJOYING EXUBERANT OPTIMISM in the first few months of 2013, the mood of the financial markets has become subdued yet volatile.
The main factor unnerving investors is the growing uncertainty over the US Federal Reserve’s willingness to buy bonds at the current scale of $85bn (£55bn) per month. Share prices are high by historical standards, but we have seen significant falls since the May peaks – more than 5% in the US and 8% in the UK, before partly recovering. More significantly, yields on government bonds have risen since early May. In absolute terms, ten-year yields are still low, just over 2% in the US and the UK, and well below 2% in Germany. But in proportional terms, yields rose by almost 40% before easing slightly. As capital values plummeted, bond investors incurred big losses and acute volatility is spreading to the currency markets.
These dramatic movements were triggered by fears that the Fed may start “tapering” its bond purchases as early as this summer. Chairman Ben Bernanke tried to reassure the markets that policy will not be tightened until recovery is much stronger. But differences of view on the Fed’s policy-making committee have unsettled investors, and the negative ripple effects have been felt globally.
We have entered a semi-perverse environment, where good news on the economy is bad news for the markets, because better growth prospects heighten fears that central bank support may be withdrawn earlier than previously thought. Economic figures do not justify such fears. Growth is mediocre in the US, negative in the eurozone, and slowing in China. But there are fundamental concerns that massive injections of liquidity are distorting asset markets, while increasing risks of bubbles. Future inflation remains a threat, in spite of recent benign figures, and investors are nervous.
The massive Japanese monetary stimulus, introduced a few months ago as part of prime minister Shinzo Abe’s forceful initiative, known as “Abenomics”, is facing obstacles. The Nikkei, after initially rising by 37%, has dropped more recently by some 19%, reducing considerably the beneficial impact of higher share prices. On the forex market, where boosting exports by pushing down the yen was a key aim of “Abenomics”, there was a similar reversal. The yen’s initial fall against the US dollar of more than 10% was followed by a sharp rise of more than 7%, mainly in reaction to uncertainties over the Fed’s plans. The most difficult component of Abe’s plan remains implementing tough structural reforms that will affect entrenched vested interests. Unless the opposition can be overcome, Japan’s growth will remain feeble.
The eurozone remains the weakest link in the global economy. GDP fell by 0.2% in the first quarter of 2013, the fourth consecutive quarterly decline, and was 1.1% lower than a year earlier. Among the large economies, France, Italy and Spain all recorded declines in Q1. Germany, the largest and strongest economy, recorded minimal growth of only 0.1%. In full-year terms, eurozone GDP is forecast to decline for two full years in a row: down 0.6% in 2013, after 0.6% in 2012. Forecasts are still being downgraded. The good news is that the pace of decline is easing, and we may see positive growth in the second half of 2013. But the situation is grim. Eurozone unemployment rose in April to a new to record high of 12.2%, well above jobless rates in the US (7.6%) and the UK (7.8%).
There are no immediate risks of a new major euro crisis. But there are still deep divisions over policy. Germany and other core economies are stressing the need for budgetary discipline and structural reforms, while indebted economies (Greece, Portugal, Italy and Spain) are calling for expansionary measures that would stop their economies from dropping further into recession. The European Central Bank (ECB) cut its key rate to 0.5% in May, and its Outright Monetary Transactions scheme (known as ECB president Mario Draghi’s “big bazooka”) is providing effective protection against sovereign default, but only if strict conditions are satisfied. Policy will remain expansionary, and rates will not be increased until 2015. But the ECB is reluctant to ease further; it will remain more cautious, and will take fewer risks with inflation, than other central banks.
In the US, housing is a key driver of the recovery. In March, house prices were 10.9% higher than a year earlier, the biggest rise in almost seven years. Consumer confidence is improving, albeit with occasional setbacks, and is being sustained by gradual improvement in the jobs market. The US created 175,000 new jobs in May, slightly more than expected. But earlier rises were revised down, and the jobless rate edged up from 7.5% to 7.6% of the workforce, as more people returned to the workforce. US growth is still mediocre, with GDP forecast to increase by only 2% in 2013. But the US is much stronger than the eurozone, where growth is negative and unemployment above 12%. The case against scaling down QE remains strong, but the markets are wary.
In the UK, the situation is slowly improving. GDP rose by 0.3% in Q1 2013, better than expected, removing the immediate threat of a triple-dip recession. When the official statistics are revised, we may find that there was no double-dip recession last year. But UK growth is too weak, and output is still below pre-recession levels. Early indicators for the second quarter of 2013 are promising.
As UK growth forecasts are being upgraded, earlier pressures for more QE are fading. Incoming Bank of England governor Mark Carney will be cautious. This is good news. UK inflation remains higher than in the US and the eurozone. Attempts to boost growth through more QE and a weaker pound could prove to be counter-productive – providing minimal support for exports, but damaging domestic demand as higher inflation squeezes real incomes.
David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist