THE financial markets remain very bullish and share prices rose again to new all-time highs. This optimism is not entirely fatuous, but it is excessive. The recovery is real, and risks of a new recession have eased. But the upturn is weak by historical standards, and there are risks that cannot be shrugged off. Investors have accepted that a market correction is likely in the next few months. Though global growth will continue, share prices will very probably fall back from current elevated levels.
Heightened geopolitical tensions, unless managed carefully, could derail the recovery. The most acute threat is the impasse in Ukraine. A military conflict with Russia remains unlikely. But a festering quarrel, with sanctions and reprisals, could damage the global economy and Europe in particular. There are also worrying tensions in east Asia, as both China and Japan are adopting assertive nationalistic postures. Numerous ongoing disputes, relating to sovereignty over maritime demarcation lines and flying zones, risk getting out of control due to a miscalculation. So far, the main east Asian actors have exercised self-restraint. But tensions are dangerous at a time when the emerging markets are facing new pressures.
China has coped competently with the problems facing it. The slowdown from double-digit growth rates in previous decades to 7%-8% per annum in recent years was relatively smooth, in spite of the global financial crisis. But the pressures facing China worsened recently in the face of rising bad debts, heightening risks that the economy would slow too abruptly. To pre-empt threats of a hard landing, the authorities announced new spending measures, focused on railways and housing. They have also allowed large net falls in the renminbi, reversing at least temporarily the policy of encouraging gradual rises in the currency. While China’s prospects remain broadly positive, the situation has become more difficult, and the rebalancing of the economy will take longer.
Other emerging economies, which have faced volatile capital outflows triggered by the US Federal Reserve’s tapering, are weaker and more exposed than China. In some instances, eg, Turkey, Thailand or Argentina, domestic political tensions have accentuated problems. Pressures eased early in April, as emerging market currencies and stock markets recovered. But uncertainties persist, and renewed speculative attacks can be expected. The strains unleashed by tapering are only a foretaste of the volatility one may expect when US rates eventually start increasing.
Higher interest rates are unlikely to be considered by any major central bank in the near future. Monetary policy will remain easy almost everywhere. But differences of emphasis are emerging. In the US and the UK, the key uncertainty is when rates will start rising. The Fed and the Bank of England are both stressing that imminent increases are unlikely, but it is clear that their next policy move will be one of tightening. In contrast, policy easing is likely in Japan and the eurozone. As the effects of ‘Abenomics’ remain disappointing, with Japan’s GDP growing by a miniscule 0.2% in the fourth quarter of 2013, there are fears that the increase in Japan’s consumption tax from 5% to 8% will cause serious damage. The stimulus package launched by the government to counter any downturn is unlikely to suffice. The Bank of Japan is under pressure to increase further its already massive quantitative easing programme. While such a move is probable, it is by no means clear that it will succeed in stimulating growth.
In the eurozone, annual consumer inflation fell to a four-year low of 0.5% in March, and the European Central Bank is preparing the ground for more policy easing. The ECB kept official rates unchanged at its 3 April meeting. But we expect its main refinancing rate to be cut from 0.25 to 0% in the next three months, while the deposit rate on reserves held will probably be cut from zero to negative. German opposition to an expansionist stance is diminishing, and the ECB may even consider launching outright QE. Though other central banks have used QE regularly, this would be a radical step for the ECB. But with eurozone unemployment at 11.9%, considerably higher than in the US and the UK, and with GDP forecast to grow by only 1.1% in 2014, the ECB is under pressure to act. But as in Japan, the effectiveness of such a step is likely to be doubtful if there are no major structural reforms that would enhance the supply potential of the eurozone economies.
The US economy is continuing to make gradual progress, mediocre by historical standards but stronger than in Japan and the eurozone. GDP growth in the fourth quarter of 2013 was revised slightly up to 2.6%, and our full-year forecast for 2014 is unchanged at 2.7%. After a hard winter, US consumer confidence rose to a six-year high in March, and house prices are increasing at a solid pace of more than 13% per annum. The labour market is improving, supporting the view that disappointing figures in previous months mainly reflected bad weather, and were not due to an underlying worsening.
The US economy created 192,000 new jobs in March. While this is fewer than expected, the trend is positive, and figures for January and February were revised up by a total of 37,000. The March jobless rate remained unchanged at 6.7%, but this is because more people are joining the workforce. Given this background, the Fed is likely to continue tapering its bond purchases at a steady pace of $10bn (£6bn) per month. But with core annual inflation below 2%, the Fed will try to reassure the markets that official rates will not start rising until well into 2015.
The UK is continuing to enjoy its unusual status as the fastest-growing G7 economy in recent months. But longer-term comparisons show a less flattering performance. UK employment growth has been strong, but productivity is weaker than in other major economies and our public finances are still poor. The markets expect UK official interest rates to start increasing around the middle of 2015. But many heavily indebted consumers may find it difficult to cope with higher repayments on mortgages and other loans.
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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