THE world’s major stock markets, after recovering the sharp losses they incurred early in 2016, have entered a period of semi-paralysis. Prices are fluctuating daily and a mild downward tendency has again become apparent.
Instances of volatility and illogical behaviour, mainly in the forex markets, are now more frequent. The economic outlook remains subdued. While Japan and the eurozone have reported stronger than expected growth in the first quarter of 2016, the US and China have decelerated. But overall, global growth expectations weakened further, and the overriding perception remains that the pace of expansion in most major regions will remain weak in the next few years.
There is widespread agreement that it is unrealistic to expect a return to the relatively strong growth rates recorded before the 2008 financial crisis. Overall, the mood of the markets remains cautious and unsettled, and the foreign exchanges are particularly volatile. The dominant short-term uncertainties relate to the US Federal Reserve’s interest rate policies, the health of the Chinese economy and the EU Brexit referendum in the UK.
Japan’s GDP expanded at an annualised rate of 1.7% in the first three months of 2016, well in excess of the expected 0.3% increase. The higher first quarter growth reversed a GDP contraction in the last quarter of 2015 and ensured that Japan has avoided another technical recession, defined as two consecutive quarters of negative growth.
But, in spite of the better than predicted first quarter growth, Japan’s full-year GDP growth forecast for 2016 was raised only marginally (from 0.5% to 0.6%), and the Bank of Japan indicated that it will not alter its ultra expansionary monetary policy, and may probably even consider further stimulus. Given this background, the steady strengthening in the yen against the US dollar that was apparent in recent months started to move into reverse during May. The dollar has risen some 3.5% against the yen in recent weeks, although it is still much weaker than six months ago. The BoJ’s policies justify a weak yen. But it is strange that the yen strengthened earlier in the year, when there were serious risks of Japanese recession, but the yen started weakening after Japan’s GDP recovered strongly in the first quarter.
The dollar/euro rate has followed a similar pattern, giving the impression of diverging from growth trends. Eurozone GDP growth accelerated from 0.3% in Q4 2015 to 0.5% in Q1 2016, largely reflecting stronger expansion in Germany and France. Germany, the eurozone’s largest economy, grew by 0.7% in the first quarter of the year, faster than expected and its strongest performance in two years. The French economy also gathered speed in Q1 2016, growing by 0.5%, after 0.3% growth in the fourth quarter of 2015. In reaction, the European Central Bank suspended plans to reduce its deposit rate further. But, with eurozone’s annual inflation rate at -0.2% for April, it is not surprising that senior ECB officials have made it clear that a cut in rates remains a possibility “in principle”.
These conflicting messages have unsettled the forex markets. In spite of the stronger eurozone growth in Q1 2016, the euro has started falling against the dollar since early May. Our full-year 2016 eurozone GDP forecast has been upgraded to 1.6% and, if present forecasts are correct, eurozone GDP growth in 2016 will match that of the US, an unusual state of affairs. But neither the ECB, nor most economic analysts, have sufficient confidence in the eurozone’s ability to sustain its recent improved growth performance.
US GDP grew at an annualised rate of 0.5% in Q1 2016, after 1.4% growth in Q4 2015, lower than expected and the slowest pace of US expansion in two years. American consumers reduced their spending, and companies cut sharply their business investment, in reaction to worsening global financial conditions and falling oil prices. Although oil prices recovered in recent months, and US GDP growth will probably strengthen somewhat in Q2 2016, the net impact of recent developments is a marked downgrading of full-year 2016 US GDP growth, to 1.6%.
The US labour market, though stronger than the GDP figures, also show signs of slackening. The US economy created 160,000 new jobs in April, 40,000 fewer than had been expected by most analysts. The US unemployment rate remained stable in April, at 5%, but earlier estimates of job increase in February and March were revised down. The US labour participation rate also fell, to 63% in March from 62.8% in April. Overall, the April 2015 job figures were mediocre.
However, initial market expectations that the disappointing US labour market and GDP figures would lead the Fed to delay raising interest rates have proved premature. With US inflation and retail sales edging up, the recent Fed minutes have been more hawkish than expected, and have produced a radical change in expectations about interest rates. In sharp contrast to market views that signalled only a few weeks ago that global and domestic headwinds will force the Fed to wait until the end of the year before tightening, a growing number of economists are now predicting a small rise in US rates in June or July 2016. Consequently, after falling until recently the US dollar started to strengthen, in spite of weaker growth prospects. The situation is fluid and a Fed hike is not yet certain. Risks of a new relapse in the equity markets may still persuade the Fed to wait. But their willingness to consider an early policy tightening proves that senior Fed officials are aware of the risks associated with the current abnormal situation.
Dominated by Brexit
The UK markets continue to be dominated by the acrimonious Brexit referendum, which is bound to intensify further before the 23 June vote. Both sides of the debate are deliberately exaggerating the arguments they are using. It is clear that changing perceptions over the risks of Brexit occurring have been a key factor influencing movements in sterling.
After falling sharply earlier in the year, when the “Leave” campaign appeared to make good progress, the pound strengthened more recently, in reaction to evidence that the “Remain” camp is gradually edging ahead. The polls are close, and it is still difficult to predict the outcome. But the betting odds are predicting a clear victory for staying in the EU. Most market traders and analysts also believe that the UK will vote to stay.
Meanwhile, the referendum has heightened uncertainties and might have contributed to the economy’s weakness this year. UK quarterly GDP growth slowed from 0.6% in Q4 2015 to 0.4% to Q1 2016, and there are worrying signs that the pace of expansion has decelerated further in Q2. Our full-year forecast for 2016 has been downgraded to 1.8%. It is therefore not surprising that the Bank of England’s May Inflation Report has conveyed a subdued message of weaker growth and higher unemployment than in its February Report, and has signalled that any thought of raising interest rates is off the agenda for the time being. The Monetary Policy Committee will probably wait until the fourth quarter of 2016 at the earliest before considering a rise in interest rates.
David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist.