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Cheerful markets underpinned by subsiding fears

THE MARKETS have been remarkably cheerful over the summer months. Uncertainties over the timing and scale of any tapering by the Federal Reserve will remain a major concern for the foreseeable future, but the turmoil that greeted Fed chairman Ben Bernanke’s signal that it might start scaling down its asset purchases as early as September 2013 subsided without causing too much damage.

The markets still fear and dislike the idea of tapering, and it is difficult to predict what will happen when it actually comes to pass. In the longer term, withdrawing the monetary stimulus injected in recent years remains the biggest challenge facing policy makers. But, in spite of major risks facing the world economy, short-term optimism appears likely to persist. Share prices are at or near multi-year highs, and the trend in most centres is likely to remain upwards.

The bond markets are also less nervous, as the turmoil that followed Bernanke’s message has eased. But renewed inflows into bonds, or even a reversal of outflows, are unlikely. With growth in 2014 likely to be stronger than in 2013 in both Europe and the US, it is realistic to expect bond yields to rise, and bond prices to fall further, which inevitably increases the attraction of equities for investors.

Wave of the future
We are also now seeing greater optimism over the prospects of the G7 economies vis-à-vis the emerging markets, including China. This reverses the post-2008 position, a period during which the emerging markets have been seen as the “wave of the future”, in contrast to the stagnant and heavily indebted G7. Countries such as China and India will still grow faster than Europe and the US. But the problems confronting many emerging markets are now mounting, and there are serious risks of “hard landings”.

It is not surprising that the Shanghai stock market has fallen in recent years, in contrast to the general upward trend in share prices. Global GDP growth is forecast at 3.1% in 2013, the same mediocre pace as in 2012, before accelerating slightly to 3.5% in 2014. But next year’s additional growth will mainly reflect better performances in Europe and the US. In contrast, Chinese growth is likely to be slower in 2014.

US economic performance has improved in the past year, driven by a stronger housing market and by a patchy recovery in the labour market. The US is now the world economy’s locomotive, even though its recovery is still disappointing by historical standards. US GDP rose at an annualised rate of 1.7% in the second quarter of 2013, better than analysts expected. But year-on-year growth was only 1.4%, after 1.3% in the first quarter, a weak figure given the strength of other indicators.

Although the economy will improve over the next two years, our central forecast is that US growth will slow from 2.8% in 2012 to 1.5% in full-year terms in 2013, before accelerating to 2.5% in 2014. US house prices rose by 12.2% year on year in May 2012, the biggest annual increase since March 2006. Low interest rates, a stronger jobs market and a limited supply of new homes are all boosting demand and pushing house prices up. But, so far, there is no evidence that a new US house-price bubble is emerging.

Underlying trends in the US labour market are positive. But progress is uneven and there are occasional setbacks. In July 2013, the US created 162,000 new jobs, fewer than expected. But the jobless rate fell from 7.6% in June to 7.4% in July. With the US unemployment rate likely to fall to 7% in the next few months, the Fed will probably feel sufficiently confident to start tapering its asset purchase programme later this year.

However, there are renewed risks that political stalemate in Congress over taxes and the debt ceiling may paralyse temporarily the US government. If politicians practice brinkmanship, and cannot reach an agreement, the Fed may decide to postpone the start of tapering from September 2013, the current favoured date, to December or even the early months of 2014. But official Fed rates will stay at their current level of virtually zero at least until mid-2015.

Return to growth
The eurozone economy remains weak. GDP recorded outright falls in six consecutive quarters up to the first quarter of 2013. But there are now signs that the economy is stabilising, and a return to positive growth is likely in the second half of 2013. Our central forecast still indicates full-year eurozone GDP declines of 0.6% in both 2012 and 2013, before a return to positive but modest growth of 0.8% in 2014. Concerns over a disorderly euro break-up have eased considerably, and sovereign bond yields in the periphery have fallen sharply since the end of last year.

This is mainly due to the willingness of the ECB to provide effective protection against sovereign default, but only if strict conditions are satisfied. The ECB will continue to provide ample liquidity, and will hold its official rate at 0.5% at least until early in 2015.

In the UK, the pace of activity is gradually strengthening, as GDP growth accelerated from 0.3% in the first quarter of 2013 to 0.6% in the second quarter. The UK recovery is still weak and inadequate, and output is 3.3% below its pre-crisis level, seen early in 2008. But recent surveys show rising business confidence. We expect that the economy will continue growing, with the pace improving during 2014.
With GDP now expanding at a moderate pace, and with UK inflation rising to 2.9% in June, there is no case for more QE in the near future.

Mark Carney, the new Bank of England governor, is aiming to unite the Monetary Policy Committee behind a new “monetary activism” that will focus on providing “forward guidance” about future intentions. The new approach is worth trying, even though success is not guaranteed. Reassuring businesses and consumers that interest rates will stay low for a long period is welcome. Avoiding risks of creating new bubbles through more QE is also helpful. However, forward guidance entails risks and Carney will have to demonstrate exceptional skills in communicating his intentions without unsettling the markets.

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

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