A pause in the rally
After an impressive five-month rally fuelled by signs of improving economic data in the US and hopes that the worst fears about a new eurozone crisis might have passed, financial markets have stalled in recent weeks with concerns about the eurozone once more returning to the forefront of investor concerns. The release of several key first quarter GDP figures in April seemed to confirm what markets were beginning to fear: that any rebound in global economic growth will be more anaemic than many had begun to hope. Growing resentment towards 'austerity' policies is meanwhile leading to heightened political uncertainty across Europe and creating new risks to financial stability. With the effects of the European Central Bank's (ECB) liquidity tap now beginning to run dry, equity markets have lost momentum over the past month while volatility has increased somewhat, although it remains well below crisis levels.
The official first quarter GDP figures issued by the Office of National Statistics showed the UK economy slumping to its first double dip recession since the 1970s, with GDP contracting by 0.2%, following the 0.3% decline in Q4 2011. GDP figures are notoriously prone to later upward revision and as the data is revised, it may turn out that fears of a new recession prove to be premature. Nothing can disguise the fact, however, that the UK economy is performing poorly, in both absolute and relative terms. Unlike the US and Germany, which have recovered all the output lost in the aftermath of the global financial crisis, UK output is still 4.3% below its pre-recession peak. The main driver behind the first quarter decline in growth was a 3% fall in construction output, which failed to be offset by any significant gains in services. More concerning was the overall decline in financial services output during the quarter. The one-time engine of the UK economy appears to be running out of steam. The UK's exposure to Europe, its biggest trading partner, remains a drag on potential growth and the economy is unlikely to export its way out of trouble if the current climate remains uncertain.
On a more positive note, April's CBI Industrial Trends Survey (a more forward- looking indicator) suggested the UK manufacturing sector remains on the road to recovery. The CBI figure is consistent with growth in the sector of 2% over the quarter. With the Government's opinion poll ratings falling in the wake of a series of apparent mishaps, further questions are likely to be asked over the Chancellor's austerity drive if the public sector net borrowing position deteriorates further and growth continues to contract. We continue to believe that the Coalition must pursue more active growth policies if the economy is to join the road to recovery. With inflation still running well above the official 2% target, the Bank of England's Monetary Policy Committee says it has little room to loosen monetary policy any further. It is unlikely therefore to introduce further quantitative easing (QE) when the current programme ends in June. Our view is that a further £25bn of easing in the autumn remains a real possibility, given the continued poor outlook for growth. Although equity markets have reacted calmly to the latest data, bond yields have declined (to 2.1%) and the UK equity market has started to underperform the world index. Somewhat surprisingly, perhaps, sterling has strengthened slightly.
There were mixed messages to take from the somewhat disappointing Q1 GDP figures which came in at a less than expected 2.2% annualised. The US consumer appears to be doing their part with a 2.9% increase in personal expenditure, a strong figure considering the impact of rising gasoline prices on disposable income over the quarter. Clearly the continued recovery in labour market conditions is helping to boost consumer confidence, despite real personal disposable income only rising by 0.4%. Signs that the US housing market is finally bottoming out in some parts of the US have also contributed. The rise in consumption was offset by declines in government spending, mainly defence, and a 2.1% fall in business investment.
The Federal Reserve has painted a brighter picture for growth in 2012, upgrading their forecasts and predicting unemployment will fall to a range of between 7.8% and 8% this year. The public stance of the Federal Reserve's rate-setting open market committee remains that it will hold interest rates at their current low levels until at least 2014. The committee has acknowledged the recent pick up in inflation and a more hawkish stance among committee members suggests another round of QE is off the table for now. In an election year, the prospects of policymakers in Washington making a decisive start on reducing the budget deficit are low to non-existent. Given the 'fiscal cliff ' that is approaching at the end of 2012, when expiring tax cuts and planned new reductions in public spending kick in, potentially reducing GDP by 4% (or $1tn) in 2013/14, the deficit is set to become an important battleground as soon as the new president and Congress have been elected in November.
With much of Europe now technically in recession, the 'liquidity boost' provided by the ECB's second round of three-year cheap financing for European banks in February appears to be fading. While the ECB's liquidity measures have stemmed the immediate threat of a Lehman-style credit crunch, the deep-rooted challenges facing most of the region's peripheral countries have started to rise to the surface once more, with increasing signs of popular resistance to government austerity measures in several countries. The ECB president, Mario Draghi, emphasised in a recent speech the need for new pro-growth policy measures to supplement the austerity measures being implemented in the weaker southern European states. His call for a 'growth compact' to supplement the earlier 'fiscal compact' agreed by eurozone leaders (and now awaiting ratification) appears to have won the backing of the German leader Angela Merkel.
With the most recent surveys pointing to a further contraction in manufacturing and services output, and other forward- looking economic sentiment indicators all pointing down, political tensions across the eurozone are rising; all eyes are now on the outcome of forthcoming elections in France and Greece. As expected, Francois Hollande defeated Nicolas Sarkozy in the French presidential election and has pledged to renegotiate the fiscal treaty, something Mrs Merkel has refused to countenance. With economies in some of the peripheral countries heading backwards, fears about the solvency of banks in Spain and Italy have also intensified in recent weeks. Bond yields in both countries remain close to unsustainable levels. The German economy meanwhile continues to strengthen. Retail sales rose by 2.3% year-on-year in March, and unemployment is still at a two-decade low, underlining the increasing divergence in the fortunes of the north and south of the eurozone.
CHINA AND JAPAN
Further evidence of China's economic slowdown came with GDP declining to 8.1% in the first quarter of year, its lowest rate of growth in 11 quarters. The fundamentals may be stronger than the headline figures suggest however. For example, the manufacturing PMI survey has increased for five months in a row since November, suggesting output in the sector is continuing to expand. The decline in money supply looks to have reached the bottom after M2 growth accelerated the most in 12 months. Premier Wen Jiabao moved to help boost the economy by cutting banks' required reserve ratios and credit easing to give smaller companies better access to funding. With inflationary pressures now looking under greater control than before, there is scope for further monetary easing. The longer-term challenge remains how successfully China is able to move to a domestic-demand driven economy. Investment currently remains at nearly 50% of GDP, an unsustainable level.
In Japan, continuing deflationary pressures and another pick up in the yen have pushed the Bank of Japan to intervene for the second time this year with the central bank increasing the size of its asset purchasing programme (QE) by another ¥5tn ($61.7bn). This included another ¥10tn of bond purchases and reducing the amount available under its low-rate lending facility by ¥5tn. Since the Bank of Japan unexpectedly added ¥10tn to the programme in February and announced it would target an inflation level of 1%, the yen has declined significantly against the dollar, benefiting many of Japan's large cap exporters, helping the Nikkei index erase the losses made from last year's tsunami. However, the yen's recent strength has seen the currency make gains against all major G10 currencies throughout April and threatened to derail an export-driven return to growth.
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