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Dissatisfaction with ‘European project’ threatens recovery

EVENTS IN UKRAINE could still spiral out of control. But the markets, focusing on the economy, remain exuberant. Share prices touched new record highs, even though risks in Japan and China are rising, and disappointing US and eurozone GDP figures have led to a downgrading of our 2014 growth forecasts.

The puzzling relationship between buoyant equities and falling bond yields is a clear warning that the current optimism does not necessarily signal a stronger economy. Better growth prospects would normally produce rising bond yields, in anticipation of monetary tightening as spare capacity vanishes. But the large falls in yields since January have been driven by the flood of liquidity that the central banks are creating – by inflating their balance sheets, and by holding official interest rates at virtually zero or, after the European Central Bank’s recent move, at negative. But this cannot obscure escalating global threats indefinitely.

Japan and China could derail the global recovery even if geopolitical tensions in East Asia miraculously vanish. The recent hike in Japan’s sales tax from 5% to 8% entails major fiscal tightening of more than 1% of GDP, and could reverse the expansionary effects of Abenomics. The Bank of Japan’s quantitative easing (QE) programme is aggressive, but its benefits could be more than offset by the tax increase. The risk of a new Japanese recession cannot be dismissed. Japanese growth was strong in Q1 2014, as consumers brought spending forward in anticipation of the tax rise. But outright GDP falls can be expected in Q2 and possibly Q3, as consumers retrench and cut spending. Japan’s core inflation is now in positive territory. However, this will not produce higher growth, unless controversial structural reforms can be implemented in the face of strong political opposition by powerful vested interests.

In China, annual GDP growth slowed to 7.4% in Q1 2014, and most analysts expect a further deceleration. Though weaker growth is consistent with the official aim of restructuring China’s economy, there is still a real threat of hard landing, as the overblown property market worsens the bad-debt problem facing the financial sector. China has so far performed well, but securing a smooth adjustment may be difficult. The Chinese authorities, fearing an abrupt slowdown, have eased monetary policy further, by cutting the amount of funds that banks must hold in reserve against lending to the agricultural sector and small enterprises. But such measures can only have a limited effect. An underlying improvement will require tough political decisions, eg, financial liberalisation and reducing the inefficient state sector.

Deep dissatisfaction
Hopes that the eurozone economy is out of danger have been dampened by weak GDP figures, and by the success of anti-EU parties in the European Parliamentary elections. Growth in the first quarter of 2014 was a mere 0.2%, rather than the expected 0.4%. Divergences within the currency bloc remain large. While Germany grew by a strong 0.8%, France stagnated, and the Netherlands and Italy contracted. In France, both consumption and investment shrank, and a GDP decline was only avoided by strong public spending and inventory changes. It is complacent to assume that the eurozone crisis is over.

The election results showed deep dissatisfaction with the ‘European project’. As eurozone inflation fell in May to only 0.5%, heightening fears of deflation, the European Central Bank cut in June its deposit rate to negative, the first major central bank to do so, and its benchmark rate from 0.25% to 0.15%. The ECB did not start purchasing assets, but, in spite of German unease, we expect such a move in the next few months, as well as further cuts in official rates. The ECB’s measures will, in time, raise inflation, but will not solve the problem. The basic obstacle to stronger eurozone growth is lack of structural reform which hampers the region’s dynamism and supply potential. Our 2014 eurozone GDP growth forecast is downgraded to 1%.

US GDP declined at an annualised rate of 1% in the first quarter of 2014, lower than expected and the worst figure in three years. But the markets took the view that the GDP fall is not as bad as it looks. The very cold winter depressed activity. Output also fell because companies slowed the pace of inventory accumulation. But growth will benefit when stocks are rebuilt in the second quarter of 2014. Overall, the US economy is growing, and remains stronger than Japan and the eurozone, but the pace is slowing. Our GDP growth forecast for 2014 is revised down to 2.1%.

The housing market is cooling. House prices remain robust, but the 12.4% year-on-year increase in March 2014 was the smallest since July 2013. The jobs market is still mediocre but is improving. The US economy created 213,000 new jobs in May, marginally more than expected, and the jobless rate remained unchanged at 6.3%. Employment is now above its pre-recession level. But getting to this point took much longer than in earlier downturns and, given the increase in population since 2008, the US is still not creating enough jobs. The Fed will persevere with its current tapering programme, which entails reducing its bond purchases at a steady pace of £10bn per month. However, the US economy has not yet returned to normal, and the Fed will not raise official rates until mid-2015 at the earliest.

The UK recovery is gathering momentum. In the first quarter of 2014, UK GDP recorded quarterly growth of 0.8% and annual growth of 3.1%, stronger than in the US and Germany. But the clamour for early increases in official interest rates is intensifying, and this is damaging. The markets have brought forward the timing of the first likely rise in UK official interest rates to the first quarter of 2015. A growing minority of analysts expect the first increase will occur this year. An early rise will be harmful. The upward pressure on sterling will intensify, making UK exports less competitive, and many heavily indebted consumers will find it difficult to cope with higher repayments on mortgages and other loans. With inflation below target, and with muted wage rises, there is no need to raise rates soon.

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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