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Markets cannot defy the economic realities indefinitely

THE UPBEAT MOOD of the financial markets, reinforced by strong US job figures, has pushed share prices to new multi-year highs. The S&P 500 approached its all-time high in the first half of March; other stock market indices also surged. But the hard reality remains that the world economy is facing serious obstacles to a sustainable recovery. Many growth forecasts are being downgraded. The eurozone is in recession, with GDP likely to fall in 2013. The US is doing better than other regions, but its outlook is still mediocre. Even China is facing difficulties; growth is slowing, at a time when concerns over rising inflation and a property market bubble are forcing the Chinese authorities to tighten policy.

The present situation is risky and potentially unstable. The main force driving the exuberance is the expectation that aggressive injections of huge amounts of cheap money by the main central banks will continue in the foreseeable future. Hopes that the real economy will improve are playing a minor role only, even in the US. Indeed, if growth picks up significantly, the effect could be perverse, because fears of higher interest rates would almost certainly push up bond yields and depress equities. However, since real growth is likely to remain weak in the foreseeable future, it is reasonable to ask whether the reliance on ever-increasing monetary accommodation can sustain indefinitely buoyant financial markets.

Sequester effect

The US economy created 236,000 new jobs in February, much more than the expected increase of 160,000; the jobless rate edged down from 7.9 to 7.7%. Construction jobs rose by 48,000 – the biggest increase in almost six years – confirming the housing upturn. US house prices rose by some 7% in the year to December 2012. But, in spite of the positive news, there is a risk that the “sequester”, the $85bn obligatory budget cuts that came into effect on 1 March, will slow US growth.

Even if the politicians agree to modify the sequester, the Federal Reserve is determined to maintain ultra-low official rates at 0-0.25%, and to continue with bond purchases totalling $85bn per month until the US jobless rate falls to 6.5%. This is unlikely to happen before mid-2014. Meanwhile, GDP growth in 2013 is forecast at 2%, much stronger than in the eurozone, but slightly lower than in 2012 and weak by US historical standards.

The eurozone recession deepened further, as GDP fell by 0.6% in Q4 2012 compared with Q3, the region’s worst performance in almost four years. The fourth quarter contraction was not confined to the weak periphery. Germany, the largest and strongest regional economy, shrank by a surprisingly large 0.6% in Q4, while France’s GDP fell by 0.3%. The eurozone in total recorded declines in every quarter of last year; in full-year terms, GDP declined by 0.6% in 2012, a worse performance than in the US, UK and Japan. This year, the economy is expected to improve slowly. But for 2013 as a whole, eurozone GDP is still expected to fall by a further 0.2%, one again worse than in other major regions.

Limited benefits

Threats of an imminent euro collapse have eased since the height of the crisis in 2011. The European Central Bank (ECB) stands ready to buy the sovereign bonds of weak countries, if they are prepared to accept prescribed conditions of deficit-reduction and structural reforms. But national pride has so far stopped countries such as Spain from asking for help, and this limits the benefits of the vital ECB support.

There are also mounting risks that new crises may erupt. Cyprus is facing severe banking pressures and urgently needs support. But difficulties have emerged, reflecting differences over burden sharing. An early agreement is still likely, but the present brinkmanship is dangerous. Cyprus is a tiny country, accounting for only 0.1-0.2% of eurozone GDP. But there could be far-reaching negative repercussions if the country is pushed into default.

The inconclusive results of the recent Italian elections could become a source of instability. If it proves impossible to form a new, stable Italian government, there will have to be new elections, and this could lead to a prolonged period of uncertainty. So far, the markets have not been unduly concerned, but the situation could easily worsen. The role of the ECB will become even more critical in these circumstances. At its last meeting, the ECB decided to keep official rates unchanged at 0.75%. But in the face of negative growth and unresolved political uncertainties, we expect a reduction to 0.5% in the next few months.

In the UK, the markets are primarily focusing on the Budget on 20 March, and on Mark Carney’s arrival in July as the new Bank of England governor. Following the 0.3% negative GDP growth in Q4 2012, and the downgrading of the UK’s credit rating by Moody’s, the government is under renewed pressure to change course and abandon its Plan A for cutting the deficit.

This is unlikely to happen. Though we lost the prestigious AAA status, our rating is still very high. We cannot afford repeated downgrades. But UK economic policies will be modified, by combining further spending cuts with pro-growth measures, e.g. more spending on infrastructure, and tax cuts to encourage investment.

If the markets believe the chancellor is determined to slash the structural deficit, they will tolerate more spending on measures likely to increase the economy’s productive potential. The expectation that fiscal consolidation must be offset by more aggressive monetary policies is problematic. The markets expect more quantitative easing, even before Carney takes over. But tolerating higher inflation, for a longer period, is risky. Sterling has already weakened markedly, in anticipation of policy changes. If the pound falls further, the benefits to exports will be small. But higher inflation will squeeze businesses and individuals, and cause serious damage to the economy.

David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist

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