In this week’s bulletin:
- Nearly a year on from the ECB’s pledge to defend the eurozone, markets rise in advance of the European holiday exodus.
- Germany’s economy comes under the spotlight in the run-up to its September election.
- UK growth estimates revised upwards as business and consumer confidence rises.
À votre santé!
Bastille Day came and went at the weekend. Business, the state and the public in France and much of Europe over the coming weeks will ease towards the long holiday month of August. And as markets also prepare to go quiet for the summer break, the world’s economies are edging into the second half of the year in mixed health.
China, along with other developing economies, is weakening before the developed markets have recovered fully from recent ills. The International Monetary Fund (IMF) last week cut its forecast for global growth by 0.2% for 2013 to 3.1%, reducing China’s growth by 0.6% to 7.7%. IMF chief economist Olivier Blanchard, however, said there are “signs of hopes” in the eurozone, despite predicting a 0.6% contraction in 2013.
Beijing remains sanguine about further signs of a slowdown of its economic take-off this summer. Last week Chinese finance minister Lou Jiwei said a 6.5% growth rate would not be a “big problem”, signalling tolerance of this reduced pace. Chinese data this week revealed a 7.5% expansion of the economy in the second quarter, which amounts to the country’s weakest rate since the late 1990s.
The growth of the world’s second-largest economy has slowed now for two consecutive quarters. However, China wants to orientate the economy towards domestic consumption rather than industrial production. Official data out this week also show this economic shift is well underway, with a 13.3% year-on-year rise in retail sales as Chinese consumers start to spend rather than save their new wealth.
When Europe gets back to business in September, however, the eurozone’s economic and structural problems will remain unresolved. The recession drags on across the region. The bailout of Greece and Cyprus continues. Portugal’s crisis deepens. Ireland remains mired in bank debt. Italy and Spain are struggling.
France, once the region’s engine room with Germany, is also straining under deteriorating government debt and economic conditions, and the eurozone crisis. And, just before the pomp of its national holiday, rating agency Fitch on Friday stripped the Fifth Republic of its AAA rating. The second-largest economy in the eurozone will grow a mere 0.3% this year, while unemployment is at 10.4% and the public deficit looks closer to 4% of economic output than the 3.7% target.
September will bring two crucial events for Europe and world markets. Germany goes to the polls, offering its voters the opportunity to give their verdict on Chancellor Angela Merkel’s handling of European policy. Meanwhile, US Federal Reserve chairman Ben Bernanke is expected to give more detail of his tapering of the $85 billion-a-month asset purchases as the US economy improves.
Investor concerns about Chinese growth and the eurozone subdued last week’s equity market gains after Bernanke reiterated that a tapering of the third quantitative easing programme (QE3) would be gradual and contingent on economic data. Equity markets had a strong week with the S&P 500 Index up 2.51%, the FTSE 100 Index registering its best run for six months with a 2.66% rise, and the FTSEurofirst 300 Index and the Nikkei 225 Stock Average Index gaining 2.75% and 1.37% respectively. This summer, markets will continue to hinge on central bank policy and the good health of the global economy.
What does it take?
It is almost a year ago that European Central Bank president Mario Draghi promised to do “whatever it takes” to preserve the euro. Last week the latest round of Europe’s prolonged financial crisis reared in Portugal and Greece. Despite the severity of these countries’ debt crises, the reaction in the eurozone seems subdued.
Greece’s position remains precarious, according to its ruling troika of the European Central Bank (ECB), European Commission (EC) and IMF. Athens, despite this diagnosis last week secured a further €4.8 billion of bailout funds. Greece has pledged more public sector cuts to secure its bailout.
Meanwhile, Portuguese borrowing costs on ten-year bonds climbed to 7.27% on Friday, a seven-month high and up from 5.15% in May. Portugal’s president Anibal Cavaco Silva wants a cross-party deal in support of the country’s €78 billion bailout programme. The opposition called for new bailout terms.
Amid this latest chapter in the eurozone’s three-and-a-half-year sovereign debt crisis, the ECB has moved from never commenting on future interest rates to saying it will offer “forward guidance”. Draghi has pledged more loose monetary policy for an indistinct period, just as the Fed is defining its QE retreat. Behind this seeming volte-face there is a studious vagueness about what form this will take.
Draghi is proving adept at palliative economic medicine. The ECB is yet to buy a single bond under the Outright Monetary Transactions (OMT) scheme unveiled last September. This allows the ECB to buy eurozone countries’ bonds to control interest rates in case of speculation of an exit from the euro.
The fact of OMT’s existence seems to have calmed financial markets. Last week there was little sign of the contagion that was the talk of summer 2012. The chaos in Athens and Lisbon has not spread to Madrid or Rome. Greece’s ten-year bond yield at 10.5% is a fraction of what it was last year.
However, the eurozone remains in a parlous state. The IMF has revised its 2013 forecast for the eurozone to contract by 0.6% in 2013, after it shrank for six consecutive quarters. OMT has pacified bond speculators. But a remedy is needed for the economic ills behind the political eruptions in Portugal and Greece.
As Germany looks on and despairs at the latest incarnations of the eurozone crisis, its politicians are studiously avoiding talk of Europe in the run-up to the 22 September election. However, Germans can be certain of one result – their taxes are needed to bail out Greece. A conspiracy of silence around this uncomfortable fact and grand questions of European destiny look set to hold until after the election.
There is little appetite among Germans of all political shades for their money to relieve other European Union member states’ economic malaise. Hostility in Germany to the bailout has only grown since the first Greek rescue of May 2010. The consensus is that the European periphery has gorged itself on cheap credit and Germans are paying for their prodigal ways.
The relative health of the German economy amid the eurozone’s economic plagues, however, is starting to look less vigorous. The German economy was robust in the early years of the euro crisis, but shrank by 0.7% in the final quarter of 2012. Europe’s largest economy grew by just 0.1% in the first quarter of 2013. China’s slowdown and the eurozone’s maladies are also hitting demand for German goods.
The good news for Germany is it has a low unemployment rate and is untroubled by austerity programmes. Credit conditions may remain challenging for business in Italy, Portugal and Spain. But German business faces no difficulties securing finance, although its banks are reluctant to lend beyond its national border.
There is opposition in Germany to banking union. However, this is one remedy that could get the eurozone working. Berlin believes Brussels has overstepped its legal powers with its €60 billion rescue fund scheme, the Single Resolution Mechanism, which would give the EC authority over the eurozone’s 6,400 banks. More bank lending and a healthy German economy would be more than a palliative for the eurozone.
Confidence in the UK?
The IMF’s world economic forecasts last week harboured good news for the British economy. Along with Canada and Japan, the UK had its GDP growth figures revised upwards to 0.9% from its 0.7% estimate in April. The IMF said that GDP rose more than expected in the first quarter with business surveys suggesting strong recent activity.
Business confidence in the UK is at its highest point since May last year, according to accountancy firm BDO’s Optimism Index. However, BDO noted that figures remained fractionally below the level which would indicate the economy was expected to grow. An Institute of Directors’ survey of business leaders also found the outlook for the economy brighter than at any point since the financial crisis.
Official data last week, however, suggested that parts of the UK economy are still struggling to stir. UK manufacturers in May produced 0.8% less than the previous month, despite the fillip of a falling pound. The overall trade deficit widened to £2.4 billion from £2.1 billion as export values fell for the second consecutive month. Industry and trade will need to revive for a healthy recovery.
Consumer confidence in the UK in June rose to a two-year high, according to London-based researchers GfK NOP. However, households in the UK have more debt than their counterparts in the US, and have not used low interest rates to repay loans. The think tank Resolution Foundation has warned that 650,000 households could face debt repayments of at least half their income if mortgage rates rise higher than expected.
Last week brought sharp increases in US Treasury yields after Bernanke’s statement on reducing QE3. Bank of England governor Mark Carney’s first Monetary Policy Committee statement also asserted that market expectations had risen too far on the Fed’s comments. Households are leading the recovery in the UK. Carney will need to deliver on his hint to keep interest rates at their historic 0.5% low if he is to keep consumer spirits buoyant.
Bernanke’s subtle distinction between tapering and tightening exercised markets last week. The Fed chairman said in Boston that “highly accommodative” monetary policy was needed for the “foreseeable future”. And he said he would “push back” against tightening conditions, referring to the rise in US government bond yields.
The QE programme that has fuelled the equity market rally will be in place for some time. Bernanke’s overall dovish stance will help drive equity markets. Bernanke will appear mid-week before the House Financial Services Committee to discuss monetary policy, which given the market reaction to last week’s moderate stance is likely to again move markets.
Meanwhile, markets are also looking at the onset of the second-quarter earnings period in the US. Investors in emerging markets will also be monitoring higher dollar exchange rates and whether this will reverse capital flows and cause steep losses. Asia has been a beneficiary of QE as low US yields drove investors to look for better returns. The prospect of the Fed tapering the policy has changed this mood.
The US economy is likely to regain momentum. There is concern that Fed support will encourage the bond market to price in rates before business and homebuyers can shoulder the interest rates. But, as we have argued, the signs of recovery are evident. Fed policy will reflect the strength of this economic turnaround.