THE SETBACK experienced by most equity markets in the early weeks of 2014 proved short-lived. Share prices have risen to new all-time highs, even though the economic data has been disappointing and there are heightened geopolitical tensions over Ukraine. Even if a new European conflict involving Russia can be avoided, the global recovery is facing serious challenges.
Signs of slowdown in the US and Japan, growing debt problems in China and unresolved eurozone imbalances will all limit global growth at a time when governments and central banks are running out of firepower to counteract an unexpected downturn in activity. Excessive budget deficits virtually preclude new fiscal stimulus, while central banks in the UK and the US are already thinking seriously about exit strategies and future policy tightening.
The key question is: are the equity markets displaying a new bout of irrational exuberance that could end in sorrow? Or, alternatively, is the current optimism justified, since the global outlook still appears benign in spite of mediocre growth prospects? The right one is very probably somewhere in the middle.
On the positive side, we will probably avoid a major crash or a bear market in equities, defined as price falls in excess of 20%. However, with global growth likely to stay weak by historical standards, it is difficult to deny that the equity markets are over-enthusiastic. Bond markets do not share the optimism signalled by soaring equities. The fall in bond yields, at a time when share prices have touched new heights, is at variance with what one might normally expect, and reinforces the view that equities are overvalued. While a new recession is unlikely, it is realistic to expect an equity market correction in the next 12-18 months, with net falls in share prices of some 10-15%.
The slowdown in Chinese growth has been moderate so far. The 2014 official growth target, at 7.5%, is the same as in 2013, and is in line with the authorities’ strategy of persevering with a gradual deceleration. But there are growing concerns over the mounting bad debts resulting from China’s faltering property market. China’s first domestic corporate bond default has accentuated these fears, even though the company involved was small. China’s worsening trade position added to the mood of unease, as exports dropped unexpectedly in February, by 18.1% year on year, and the trade balance moved into deficit.
After the middle of 2013, the Chinese government gradually tightened monetary policy, by pushing up mortgage costs for home buyers and banks’ funding costs, and by allowing a faster pace of renminbi appreciation.
But, in the face of growing threats to growth, Chinese tactics have changed dramatically. The authorities have reduced money market rates and, most ominously, have allowed the renminbi to fall sharply. If this proves to be a strategic policy change, and China continues to encourage falls in its exchange rate, there could be serious adverse effects. Its trading partners in Asia would suffer and risks of a global currency war would escalate.
Disappointing US data
Most recent US data has been disappointing, with weak retail sales and industrial production figures. GDP growth in the fourth quarter of 2013 was revised down sharply, from the previous estimate of 3.2% annualised, to only 2.4%. The housing market is still relatively strong, but the impetus is slackening.
The annual rise in home prices eased to 13.4% in January 2014, from 13.7% in December, the first deceleration since June 2013. More worryingly, housing starts fell by 16% between December and January. The US job market is frail.
After very weak December and January figures, February saw an improvement, with 175,00 new jobs. But average job-creation over the past three months, at 129,000, is much lower than in the previous three months. The markets have dismissed clear signs of US slowdown. But attributing all the poor news to the bad winter weather involves an element of wishful thinking. Underlying US growth has very likely decelerated. The Fed will not consider halting its current tapering policy, unless the economy’s weakness deepens. But our US growth forecast for 2014 is being revised down slightly, from 2.8 to 2.7%.
Eurozone GDP grew by 0.3% in the fourth quarter of 2013, up from 0.1% in the third quarter and slightly better than expected. It was the third quarter of consecutive growth. All the large economies – Germany, France, Italy and Spain – recorded positive fourth-quarter expansion. Although eurozone GDP fell by 0.4% in 2013, after a 0.7% decline in 2012, activity has strengthened in recent months and we have revised up our 2014 growth forecast to 1.1%. But the eurozone’s economy will continue to underperform compared to the US.
Unemployment is stuck at 12%, much higher than the 6.7% US jobless rate, and the 7.2% UK rate.
Fears of eurozone deflation have eased, as annual consumer price inflation stayed at 0.8% in February, the same as in December and January. Core inflation, which excludes energy, food, alcohol and tobacco, rose to 1% year on year in February, slightly higher than expected, making it easier for the ECB to reject pressures for easing monetary policy at its meeting on 6 March. But below-target inflation is still a concern, and the euro’s strength against the US dollar is a potential threat, because of the adverse effects on competitiveness. The fundamental problems facing the eurozone remain unresolved, and may unleash new turmoil. It is therefore still possible that the ECB will cut its official rate or launch a QE programme later in 2014.
In contrast, the UK’s Monetary Policy Committee may consider an increase in official rates before other G7 economies. But a rise in UK rates before mid-2015 would be premature and potentially damaging. In spite of reasonably strong growth in recent quarters, the UK economy is still too fragile to cope with higher interest rates.
David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist