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Macro View: Resolution of geopolitical threats will not lessen risks

AFTER a patchy start to the year, the financial markets have shown renewed strength. Equity markets have risen to multi-year highs, underpinned by optimism about the outlook. Growth forecasts are being revised up for key G7 economies – notably the eurozone and the UK.

Lower oil prices, in spite of their adverse effect on energy firms and on oil-exporting countries, are pushing up short-term growth. Lower food and commodity prices are also boosting incomes and economic activity. But, in spite of the improved outlook, threats are lurking. If tensions with Russia over Ukraine escalate, the modest progress now apparent in Europe could be derailed. Islamic State and Iran remain potential global dangers. Even if geopolitical flash-points are contained, major economic risks will persist: the vulnerability of key emerging economies; an abrupt Chinese slowdown; Greece and the eurozone; and, above all, the expected start of US Federal Reserve tightening later this year.

Long-standing financial relationships have been turned upside down. We are in uncharted territory. Negative interest rates, which used to be a rare phenomenon relevant only to small economies such as Switzerland, are now common across a wide range of European assets. It remains to be seen to what extent this anomaly will encourage reckless behaviour on the part of investors that are increasingly hungry to receive a positive return on their money.

The yield gap between ten-year US Treasuries and ten-year German Bunds is the biggest in almost 30 years. The yield spread of almost two percentage points between the US and the eurozone cannot be explained by economic fundamentals, even if long-term US growth is set to remain higher. A correction is almost inevitable. When it occurs, it could be violent. The strong dollar and volatile oil prices also foreshadow market turbulence, and tensions may worsen when the US Fed starts raising interest rates.

Major economies such as Brazil, Russia and Turkey already face speculative pressures against their currencies. China’s GDP rose by 7.4% in 2014, the lowest rate since 1990. After overtaking the US last year as the world’s biggest economy in purchasing power terms, China will almost certainly slow in the next few years; the official medium-term growth target has been lowered to 7% from 7.5%.

So far, China’s slowdown has been orderly. But the authorities have acknowledged that the country’s growth model is flawed. Major changes are needed, with emphasis on the quality of life, even if the result is reduced investment and weaker growth. China’s leaders cannot afford to allow a precipitate halt to growth, which may be triggered by the debt burden facing businesses and banks. The risks of a “hard landing” will be exacerbated if China’s low inflation renews its fall. To mitigate short-term dangers of bankruptcies and job losses, China’s central bank cut its benchmark one-year lending rate by 25 basis points, to 5.35%, the second reduction in three months. We expect further interest rate cuts in the next few months, and other forms of monetary easing, to contain the dangers to the economy of China’s huge debt mountain.

A dangerous  game

The launch of the eurozone’s QE programme, promising to buy bonds totalling €60bn (£42.4bn) per month at least until September 2016, has buoyed the markets. The euro fell against the US dollar to lows not seen since 2003, making exports more competitive. The weak euro has also helped to ease risks of prolonged deflation, even though consumer prices are in negative territory. Share prices rose and growing confidence pushed down yields on periphery sovereign bonds.

Eurozone GDP growth forecasts have been upgraded for 2015 and 2016, but Greece remains an unresolved issue. Though a major crisis was averted after the election of the anti-austerity Greek government, the compromise only provided short-term relief. As deadlines are rapidly approaching, there are serious risks that Greece may be forced to renege on its debts and leave the single currency. Everyone hopes and expects that this will be avoided. But Greece and its creditors are playing a dangerous poker game. A miscalculation may easily produce the very result that everyone is desperate to avoid.

In the US, the dominant market event was the labour market report; it showed the economy created 295,000 new jobs in February, more than expected. The jobless rate fell to 5.5%. Some Fed officials consider this as near to full employment, signalling the need to start raising official rates. This view is not unanimous. Most Fed decision makers indicated at their last meeting their intention to be “patient”, implying no tightening until mid-2015, because economic performance is still mediocre on some measures.

GDP growth slowed sharply in Q4 2014, to an annualised rate of only 2.2%, below the 5% rate in Q3. Productivity is slowing. The housing market is showing signs of weakness, which could dampen confidence. But this will not reverse the inclination to start raising rates. Unless there is an unexpected relapse in the jobs market, it is increasingly likely that official rates will start going up by June. This will create huge challenges and threats for the US and the wider global economy.

After a soft patch in the final months of 2014, there are signs that the UK economy is gathering momentum. The labour market remains strong, with employment rising and unemployment falling. Lower inflation, driven by falls in energy and commodity prices, has underpinned disposable incomes and will support UK growth in 2015. Calendar-year GDP growth in 2014 was 2.6%, stronger than in other G7 economies.

Lower inflation, and the prospect that interest rates will remain low for longer than previously predicted, are the main reasons for upgrading forecasts for the next few years. In 2015, GDP growth is forecast to accelerate to 2.7%, lower than in the US but still stronger than in the eurozone. Annual inflation fell to 0.3% in January, a record low. In the next few months, inflation may fall below zero. While there is no serious danger of a deflationary spiral, annual inflation is unlikely to return to the 2% target before the final months of 2016 at the earliest. Against this background, official rates will probably stay at their current low levels at least until early in 2016.

David Kern is chief economist at the British Chambers of Commerce

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