WE have started the New Year with the world’s economic and financial problems on our shoulders. Equity markets have responded by falling sharply, while fixed income markets have priced out any risk of near-term rate rises in some developed markets such as the US and UK. In other countries – the euro area included – despite still resilient domestic demand growth, further monetary easing is now firmly on the table.
There are various sources for such increased concerns. First and seemingly foremost, the risks surrounding China’s economic outlook have risen. By seeking to de-peg the renminbi from the US dollar in favour of a currency basket, the authorities have led markets to believe that even they are fearful of the slowdown. So far the weakening in growth looks more like a soft than a hard landing, however. And some of the slowdown can probably be attributed to structural reforms (which will eventually be good for the economy) as opposed to a cyclical weakening. But weaker GDP growth and high-frequency data – such as business surveys, trade data and output indicators such as electricity usage, steel output and rail freight – have generated increased market volatility.
Second – and related to the slowing in China – there are fears that the sharp fall in oil prices since the middle of 2014 is not only due to increased supply but maybe due in no small part to lower demand too. Indeed, this is what a study by the Bank of England recently found – that lower prices could broadly equally be attributed to supply (US fracking and a failure of OPEC to cut production – thus far at least) and demand (the weakest global growth in 2015 since the crisis). What is normally supportive for consumers of oil in developed markets – a fall in the oil prices – is proving a breeding ground for fear.
Third, the US economy has weakened and normally bullish economists are openly talking about the risk of recession. High-yield credit spreads have risen sharply (even outside of the energy sector), which in the past have often been a sign of impending increases in defaults. A strong dollar, excess inventories and falling spending on energy investment have led to a downgrading of US prospects – consensus forecasts for growth, which were close to 3% a year ago, have fallen to closer to 2% today.
The list does not stop there. Slowing Japanese growth and low inflation has led the central bank to impose negative interest rates, and concerns are spreading to Europe – most notably in relation to the banking sector – where the ECB is expected to lower rates further below zero. But how does all this affect the UK? Being an open economy (exports and imports are reasonably large relative to overall output) the UK has tended to be buffeted by global influences in the past, and this time will be no different. So it will be critically important for UK prospects whether what we are seeing in the global economy right now represents a fundamental slowdown/recession, or whether the markets are simply in a fix over what turns out to be a temporary breather in the recovery process.
While we think that it’s more likely to be the latter than the former, financial market volatility can have a knack of being self-fulfilling. It’s not difficult to envisage a vicious cycle in which weakness and volatility in financial markets lead to a tightening of credit conditions, limiting borrowing and thereby household and investment spending, which in turn causes markets to fret more about an impending recession – and so the cycle continues.
But there are reasons to be positive for growth in the UK and across the Channel in continental Europe. While lower oil prices might signal weaker global growth, to the extent their fall is supply-driven, they also give households more disposable income to spend. Sterling’s 7% fall over the past three months should make exports more competitive, which could prove a helpful offset to fragile global growth conditions. And while the euro has risen in recent weeks it remains well below where it was in 2014. In both the UK and euro area, monetary conditions remain highly supportive of growth, helped by a recovery in both credit supply and demand (which in turn has been aided by central bank action). The fact that banks globally are far better capitalised than they were a decade ago means that the financial sector should prove more resilient to a downturn in either growth or market sentiment than in the past.
In summary, recent market moves should not be underestimated; they have shown their capacity to have important economic ramifications in the past. But equally we should not ignore the positives, which may well insulate economies from a more pernicious feedback loop initiated by an overly-pessimistic financial market interpretation of events. Being the UK’s largest trading partner, it will be important to monitor developments in the euro area economy closely for any signs that global economic and financial fragility are moving closer to home. For the time being at least, European growth expectations have remained remarkably stable in the face of rising uncertainty.
George Buckley is UK chief economist at Deutsche Bank