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Macro View: January rout leaves policy makers in a state of heightened uncertainty

THE January 2016 market rout was followed after a brief respite by renewed downward pressures. Falls in equity prices gathered momentum in the first half of February and some markets touched five-year lows. Though prices recovered partially and the mood improved slightly, it is too early to talk about a sustained recovery.

Analysts and policy makers are in a state of heightened uncertainty and are trying to understand what caused the massive crash. Many factors could be blamed: plummeting oil prices, risks facing China, premature Fed tightening, and negative interest rates that undermine bank profits. All these may have played a role to some degree.

If one needs more reasons, one could add to the list the European migrant crisis and geopolitical risks such as Syria. With many markets entering “bear market territory” (for instance, share prices falling by more than 20%) before recovering somewhat, one cannot dismiss warnings that plunging stock markets may foreshadow an imminent recession.

Given the darkening mood, central banks will be forced to postpone plans to raise official rates. In their recent comments, the ECB and the Bank of Japan have acknowledged this new reality, and are now seriously considering further stimulus. In contrast, the US Fed and the Bank of England are trying to persuade the markets that early rate increases are still a realistic option. But most traders are now inclined to disregard these warnings.

Febrile mood
Given the febrile mood in all markets, there is a temptation to join the gloom mongers even after the partial rebound. Clearly, global economic prospects are likely to remain poor. The OECD downgraded its global forecasts and our own predictions are also lower. But the evidence does not support so far extreme pessimism. While there is little chance of a sustained upturn in growth, a major economic collapse is still unlikely. The main global risk in 2016 and 2017 is the persistence of virtual stagnation, rather than a precipitate descent into a new slump.

Following the recent steep market falls, one cannot shrug off recession risks; but basic trends, notably in the US, do not support such an outcome. While key economic fundamentals will remain pedestrian and disappointing, growth is set to remain positive in most major countries and regions. Though important players such as Brazil and Russia are contracting, the broad global picture is one of weak and inadequate growth, but not one of decline. The view that stock market plunges always foreshadow economic declines has often been disproved. Nobel prize-winner economist Paul Samuelsson famously said: “The stock market has forecast nine of the last five recessions.”

US performance remains mediocre and disappointing by historical standards. GDP hardly rose in the final three months of 2015, as growth slowed to an annualised pace of 0.7%, sharply down from 2% in the previous quarter and below analysts’ expectations. A strong dollar dampened exports, and the manufacturing sector faced difficulties. Our GDP estimates have been downgraded, to 2.4% for 2015 and 2.2% for 2016. But US growth will remain firmly in positive territory and the American economy will continue to expand more strongly than most other developed nations.

Household consumption
Household consumption, while cooling slightly, remains the main growth driver of the American economy. Retail sales rose at a better-than-expected rate in January, confirming the resilience of US personal consumption. Significantly, the financial position of the household sector remains relatively sound. Although US growth will remain pedestrian, it seems unlikely that any adverse ‘wealth effects’ resulting from falling share prices would force US consumers to retrench and cut materially their spending plans.

With US house prices rising by some 5-6% per annum – a stronger rate than both wages and CPI inflation – the US consumer is likely to continue spending at a satisfactory pace during 2016. The US labour market remains resilient. The economy created only 151,000 new jobs in January 2016 – less than expected – and much less than the revised 262,000 December increase. But longer term trends show very healthy job growth, averaging more than 200,000 per month. The US jobless rate fell to 4.9%, the lowest figure since February 2008, and close to a level that many regard as “full employment”. Year-on-year wages growth edged up to 2.5%.

However, with US inflation remaining weak, expectations of future inflation falling, and the markets facing risks of renewed turmoil, the Fed will almost certainly postpone any plans of further tightening. Chairman Yellen will not reverse the December 2015 increase in rates, but she will almost certainly wait at least until the middle of the year before making a further move towards ‘normalising’ interest rates.

The eurozone economy remains sluggish. GDP growth in Q4 2015 was 0.3%, the same as in Q3. Year-on-year growth in Q4 was 1.5%, lacklustre but confirming a slow improvement over the year. However, the persistent growth disparity between individual eurozone members highlights underlying weaknesses. German GDP growth was 0.3% in Q4, in line with the region’s average. But France was weaker, at 0.2%, while Italy virtually stagnated, at 0.1%. Worse of all, Greece’s GDP plunged by 0.6% in Q4, providing a timely reminder that crises may erupt again if radical reforms are not implemented.

Though eurozone annual consumer inflation edged up to 0.4% in January, the European Central Bank remains concerned that below-target inflation may cause recession. Having reduced its deposit rate in December to minus 0.3%, the ECB Governing Council considered further pre-emptive stimulus at its January meeting, and one member made the unprecedented proposal to deliberately overshoot the inflation target for a limited period.

In the event, while the decision taken was to wait until the 10 March meeting before considering further stimulatory steps, it is clear that the ECB is facing very tough choices. Pushing interest rates further into negative territory could damage bank profits, in a manner that could destabilise the eurozone. The ECB will try to find ways of weakening further the euro against other currencies, while avoiding adopting formally a higher inflation target, a move that many in Germany and other Northern members would regard as highly objectionable.

In the case of the UK, global concerns were exacerbated by heightened uncertainties over the possible effects of Brexit. Although prime minister Cameron secured a deal on changing the terms of Britain’s EU membership, his challenge will be to win support for staying in the union in a referendum scheduled to take place on 23 June. UK public opinion is evenly divided and, although most businesses support remaining in the EU, there is powerful support for Brexit within the Conservative Party and also in Mr Cameron’s own cabinet.

While the markets hope that that the prime minister will win the vote, there is huge uncertainty about the outcome. This has resulted in sharp falls in the sterling exchange rate. Fears of Brexit have damaged confidence, and this gives the false impression that Britain is doing worse than other major economies. While growth is pedestrian, UK GDP growth in the fourth quarter of 2015 was stronger than in the US, Germany and France. Even so, in the face of global turmoil, the first rise in UK official rates will be postponed. A modest UK increase in rates is still possible in Q4 2016, but many traders now believe that UK tightening is only likely to occur in 2017.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce

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