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A fear of the Greeks unsettles global markets

Fears that global growth is set to slow sharply, while rising debt levels may unleash a new financial crisis, are the main themes unsettling the markets. US growth prospects have worsened, but it is increasingly difficult to maintain expansionary policies. Indeed, there are pressures for tightening. The eurozone debt crisis has deteriorated, and the markets believe that Greece will have to default or reschedule its debts. Europe and the US must curb excessive deficits and inflation. China and India are still growing rapidly, but both are pursuing restrictive policies aimed at avoiding bubbles.

Global growth forecasts are reasonably positive, but expectations may have to be lowered, and there is a distinct reduction in risk appetite. Fears of a double-dip recession are much too gloomy, but it is realistic to expect a prolonged period of anaemic growth.

Debt overhang

Excessive borrowing was a major factor in unleashing the financial crisis in 2007 and 2008, and the consequences are still limiting recovery prospects. Although the recession ended two years ago, considerable amounts of debt overhang, coupled with acute weaknesses in a few housing markets, remain major obstacles to a strong upturn. The global picture is not entirely bleak, since negative factors have been offset by positive influences: very low interest rates, stimulatory fiscal policies, huge injections of liquidity and strong growth in the BRIC economies. The net effect of these conflicting forces has been to produce positive but uneven global growth. But the recovery is facing major risks, as some of the expansionary forces will be withdrawn: deficits must be cut; interest rates will have to rise; and China and India will slow.

After average increases of 220,000 in the previous three months, US employers added only 54,000 jobs in May, which is the smallest figure in eight months. As a result, the US unemployment rate rose unexpectedly from 9% to 9.1%, reinforcing perceptions that the US economy is not creating enough jobs. This is now one of the key political issues that look set to determine president Obama’s re-election prospects in 2012.

US GDP growth also remains disappointing, after a sharp annualised slowdown from 3.1% to 1.8% in the first quarter of 2011. The weak housing market, facing a toxic mixture of oversupply, falling prices and very low demand, remains a crucial factor depressing the US consumer. As US house prices are now some 33% below their 2006 peak – and still falling – it is essential to avoid the emergence of a vicious circle where declining demand triggers renewed price falls.

But mounting US inflationary pressures will complicate the dilemmas now facing the Federal Reserve. Consumer price inflation accelerated in April from 2.7% to 3.2% – the highest level since October 2008. Core inflation, which excludes food and energy, is also rising, and the Fed is under pressure to react. However, high unemployment is still the dominant concern, and any increases in the Fed’s exceptionally low policy rate of 0-0.25% will be postponed until 2012. Once the current $600bn programme of asset purchases comes to an end in June, the Fed is planning to stop buying assets, and this will tighten monetary conditions. But if the US slowdown deepens, at a time when the budget deficit has to be cut, the Fed may have to change its plans and launch a new round of asset purchases.

After Standard & Poor’s recent decision to cut its outlook on US sovereign debt from “stable” to “negative”, Moody’s warning of a “very small but rising risk” that the US could default on its debt heightens threats to its triple-A credit rating and reinforces pressures on both Congress and the president to deal more forcefully with the deficit.

Eurozone GDP grew by 0.8% in the first quarter of 2011, stronger than expected and better than in both the US and the UK. However, recent figures reinforce the perception of a widening gap between a strong core led by Germany and a much weaker periphery. For example, Spain and Italy recorded minimal first-quarter growth, while Portugal saw an outright decline of 0.7%. In addition to this, the escalating risks of a Greek default are a highly divisive political issue.

The European Central Bank (ECB) remains strongly opposed to any form of default or so-called re-profiling (i.e. compulsory lengthening of maturities). This is largely due to the ominous implications for its own balance sheet and for many eurozone banks that are large holders of Greek paper. But some form of default may be unavoidable, given the strong opposition in Germany to repeated bailouts, though it seems unlikely that any defaults will occur immediately.

Rates of inflation

Meanwhile, with eurozone inflation at 2.7% – well above the target – the ECB will probably raise its key rate from 1.25 to 1.5% in July, which will add to the problems facing the periphery. Since tighter fiscal integration is politically unacceptable, it looks as if it will be impossible to avoid recurring crises.

UK GDP has stagnated in the last two quarters, and the government is facing demands to relax the fiscal austerity plan and proceed more slowly. But changing course at this stage would erode the UK’s credibility, and the strategy of eliminating the structural fiscal deficit must remain a major priority.

There is no risk of a new recession, and the UK’s recovery is likely to strengthen in 2012. However, growth remains fragile, and the Monetary Policy Committee is likely to hold its nerve in the near future. Although inflation was 4.4% in April, more than double the 2% target, plans for raising UK Bank Rate will be delayed until later in the year. ?

David Kern July GDP growth chart

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