THE FINANCIAL markets are still attempting to recover after the recent sharp declines. The stock market collapse in early August was a shambles. Share prices fell by more than 15% in just over a week and, even after recovering modestly, are still more than 10% below their July highs. Yields on 10-year US Treasury bonds recently touched the all-time low seen at the height of the crisis in 2008.
It is too early to say whether we have seen a fundamental change for the worse in the economic situation or simply a frenzied over-reaction. We should bear in mind that it is often said stock markets have predicted six of the last three recessions. The US credit rating downgrade has also contributed to the mood of nervousness.
However, the irony is that demand for US assets, far from declining, has actually risen since Standard & Poor’s move. In a world where risk appetite is plunging, the US is still a vital haven, whatever deep-seated problems may be facing its economy. The flight to safety has also triggered very sharp rises in gold prices and in the Swiss franc. But investment opportunities in these assets are much too narrow to accommodate the huge global flows of liquid capital.
The market collapse was triggered by a stream of poor economic news, primarily in the US and Europe, which has led to a lowering of consensus short-term growth prospects. Some of the disappointment is overdone, and is a reaction to unduly optimistic earlier expectations. Hopes that we can return rapidly to normal growth after the financial crisis were always unjustified. Even so, some recent figures were worse than expected. In the US, second-quarter growth was revised down to only 1% annualised, after a miniscule 0.4% in the first quarter. Our US GDP forecasts, which have consistently been below the consensus, are down to 1.6% for 2011 and 2.1% for 2012, unacceptably low for a traditionally dynamic economy. The level of US output has not yet returned to its pre-recession peak.
Even more disturbing is the news that US employment stagnated at zero growth in August. The jobless rate stayed at 9.1%, a number so high that it is politically explosive. This can only intensify the paralysis in Washington, as president Obama and the Republicans who control the House of Representatives fail to agree on sensible policies and blame each other for the economic mess.
In this difficult situation, the Federal Reserve’s position is even more pivotal. If circumstances change and the economy begins to recover, the remarkable statement that the Fed funds rate is likely to stay at its exceptionally low level at least until mid-2013 may be reviewed. However, given the weakness of the US labour and housing markets, we expect the policy rate to stay at its current level of 0-0.25% at least until the final months of 2012, and possibly longer. The Fed remains very reluctant to launch a new round of asset purchases, a reluctance that is mainly due to concerns over inflation and the fiscal deficit. But feeble US growth will increase pressure for just such a move.
The economic slowdown is making the future look even more ominous in the eurozone. GDP growth in the second quarter of the year was only 0.2%, which represents a sharp drop from a respectable 0.8% in the first quarter. The two largest economies performed particularly poorly: German growth was down to a minimal 0.1%, after rising by a spectacular 1.3% in the first quarter, and France’s growth plunged from a strong 0.9% to zero in the second quarter.
There can be little doubt that weaker growth will make it more difficult to manage the unresolved sovereign debt crisis. It will increase the already existing tensions between Germany and other core economies (such as the Netherlands, Austria and Finland) and the relatively weak periphery, which now includes Italy and Spain. France has also faced temporarily speculative pressures recently, and there have been serious questions about whether many eurozone banks are strong enough to withstand a Greek default, an event that the markets still expect in the next 12-18 months.
It is clear that the threats facing the eurozone have increased, and it is not surprising against this background that the European Central Bank (ECB) is under pressure to change course and modify its previous hawkish strategy. Inflation risks, which were the ECB’s main concern until recently, are now being reassessed in the face of a gloomier economic outlook.
After raising its key rate in two steps earlier in the year, bringing it from 1% to 1.5%, the ECB will almost certainly postpone any further interest rate increases, at least until the second quarter of 2012 and possibly later. And while a reversal of the recent ECB interest rate increases is still unlikely on balance, such a move cannot be ruled out if the economic situation were to worsen and banks come under increased pressure.
Weak growth has also forced a change of UK interest rate expectations. Only a few months ago, three out of the nine members of the Monetary Policy Committee (MPC) were voting for an immediate increase in Bank Rate, and the markets were expecting a first increase before the end of 2011. However, the MPC voted unanimously to keep rates on hold at the August meeting, and the markets now widely expect that Bank Rate will stay at 0.5% until at least the third quarter of 2011. Pressures for a further injection of quantitative easing have also increased, but the MPC is still reluctant to take this step while inflation remains well above 4%.
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