The first half of 2011 has been overwhelmed with financial crises both in the US and the eurozone. European challenges centre on the lingering debt crisis, which has hindered growth prospects tremendously. The extent of the debt woes are so significant that many analysts predict the issues will persist for at least a couple of years before a recovery is completely assured.
Greece heads the group of struggling countries in the eurozone, as the country will now receive a second bailout package, which was recently approved. Greece received its first bailout (to the tune of €110bn) from the EU and IMF back in May 2010, with the goal of restoring the country to private capital markets by 2013. Unfortunately, it became apparent that the country would remain closed to the private sector for much longer than initially anticipated, sparking the need for a second wave of aid. The second package will provide an additional €109bn to Greece, in order to help it meet its financing needs over the coming years.
Similar concerns exist in Portugal, which recently received a bailout package of its own. Meanwhile, debt pressures are spreading to Spain and Italy, as economic leaders attempt to stem public concerns of a deteriorating economic environment in the region. A tumultuous several months have placed a great deal of stress on the Italian bond market. A series of political and economic scandals were exposed, which led to public scrutiny and personnel overhaul. This turmoil has increased uncertainty in the region, leading Italian bond yields to surge. The European Central Bank thereby responded by reactivating the Securities Market Programme, executing large volume purchases of Italian government bonds.
One of the main obstacles of the ECB in relieving these pressures is public opposition to the bailout packages. Many are concerned that the bailout package fails to provide a sufficient level of capital as a guarantee of payment by the borrowing countries. Alternatives to cash collateral are being discussed, with real estate being offered to assure that lenders will receive their money at some point in the future. Greece has already received its first round of aid, and details of a second wave are being discussed. The progress in these discussions is crucial to suppressing public concerns, mainly since it is believed that a third wave of support is likely necessary to successfully solve the issues in the long term. Markets are currently distressed more than usual, amid speculation that Italy may also need fiscal support in the near future.
Transatlantic infection
Since the beginning of 2011, the economic outlook in the US has endured a dramatic shift. Fundamental issues linger in the country, mainly pertaining to employment struggles, a stagnant housing market, and most recently debt concerns. The Fed has appropriately modified its interest rate outlook for the long term, claiming that rates will remain at near zero levels through at least mid-2013.
The large surge in US gross debt is causing concerns regarding the country’s fiscal sustainability. Standard and Poor’s has already downgraded US sovereign debt to AA+ and Moody’s has placed a negative outlook regarding the country’s economy. The extent of the US debt is far beyond a short-term fix. President Obama has introduced a budget proposal, which would induce a steady reduction in the budget deficit over the next decade, but even under revamped conditions the US gross debt ratio will still reach 116 percent of GDP. It goes without saying that growth is extremely important in an effort to maintain a general sense of fiscal sustainability.
Economic growth has slowed in the US, and its forecasts have become far more conservative for the remainder of 2011 and 2012. This situation has led politicians to make difficult decisions. Political leaders want to stimulate economic growth, yet at the same time preserve fiscal sustainability and restraint. As economic growth continues to slow, additional spending cuts must be implemented, in order to remain on course with the plan for a reduction in the budget deficit.
While the US maintains its efforts to reach debt sustainability, there are several scenarios that could impact their goals. A further drop in economic growth, a deviation from fiscal restraint, or higher interest rates, could all have a negative impact on the country’s debt outlook. The most likely scenario of the three is a lower growth rate. Therefore, the negative outlook placed on the US by Moody’s, Fitch, and S&P seems to make sense. In fact, the weaker-than-anticipated growth pattern could lead Moody’s and Fitch to also downgrade the US to AA+, while S&P may modify the rating to AA.
Current conditions are placing depreciative pressures on the dollar. There are myriad challenges which are likely to assist in this trend. Near-zero interest rates, a widening current account deficit, slower domestic growth, political risks, and the need for several fiscal adjustments are all factors contributing to the dollar’s decline. In addition, Fed chairman Ben Bernanke has recently stated his interest in stabilising the equity markets. It is believed that the Fed will introduce additional measures, in an attempt to stimulate economic activity and demand for riskier assets. Improving public sentiment would go a long way towards revitalising the stock market, and if the central bank is successful in achieving these goals, the dollar would surely depreciate substantially. Over the next 12 months, look for EUR/USD to drift upward of the 1.50 level, with risk assets and currencies, as well as commodities, acting as the main beneficiaries of this trend.
The Fed’s claim that interest rates will remain near zero for the foreseeable future has already begun to depreciate the dollar. This trend is likely to continue against the majority of currencies. Recent underwhelming economic data has lowered sentiment, leading the central bank to continue to take action to revamp conditions in the country.
The Fed’s actions impact the values of many other currencies as well. It was projected that the yen would finally depreciate in the coming months, as a consequence of higher US interest rates – but the Fed’s intentions will stall this deprecation. Expectations for the yen to depreciate should be tempered, as the currency will retain most of its value until conditions begin to improve in the US and monetary policy changes occur.
Until recently, consensus analysis presumed a reacceleration in US and global growth for the second half of 2011 and into 2012. This positive outlook was formed as a result of fading concerns from several shocks to the economy that occurred in the first half of the year. These events included higher oil prices, which came as a result of political turmoil in the Middle East (specifically Libya), and the Japanese earthquake and tsunami, which sent equities and other risk assets in a downward spiral. Markets struggled for a considerable time to recover from these events, which should have led to faster growth and stability across the globe. However, leading indicators have failed to stabilise, and have slipped substantially over the course of the summer.
Expectations are for a continued deterioration in the coming months. According to Bloomberg, back in February the forecast for 2011 US growth was 3.2 percent. However, revised figures show that growth projections have been scaled back to 1.8 percent for the year. Since expectations are so low, it is highly unlikely that markets will be affected by these numbers in the future, since it would be difficult to surprise investors negatively. In fact, there is far more room for improvement, meaning that if there is an upward deviation from forecasts when the data is released, markets (particularly equities) could actually benefit from the relatively positive numbers.
The reluctant safe haven
In Switzerland, the Swiss National Bank intervened in the currency market on September 6, 2011, in an attempt to cap the strength of the CHF against the euro. Over the past several years, the Swiss Franc has appreciated against the euro steadily, as EUR/CHF fell from 1.6790 in November 2007 to 1.0067 in August 2011. The intervention in early September caused a swift reaction in the market, spiking the pair upward to reach a high of 1.2188 in a number of hours, before it settled around the 1.2065 level. The SNB has vowed to maintain the 1.2000 level as a base for the near future, by buying euros without limit until it feels market conditions will accommodate these price levels naturally. The SNB will surely find this task challenging, as investors continue to search for alternative investments as a safe haven during this time of global economic uncertainty. It is believed that the EUR/CHF rate will remain around the 1.2000 mark, without a strong push in either direction, until the central bank stops buying euros at such an alarming pace and volume.
The chaos in the financial markets in Switzerland was recently fuelled by the trading scandal at UBS Bank. The immediate reaction to news reports that the bank had lost $2.3bn due to unauthorised rogue trades was a sharp decline in its stock value. Investor confidence in UBS has been on the downside for some time now, and the bank had finally begun to restore stability prior to this event. Unfortunately, this latest news has impacted the bank tremendously, as all of its employees are now at risk of losing their yearly bonuses.
The glamour of gold
Amid the economic havoc that has plagued markets over the past few years, gold has posted significant gains, reaching a historic high of $1,921.15 per ounce on September 6, 2011. The consistency of the surging metal has not strayed since the beginning of the year. At time of writing it was trading around the $1,800 level, and many believe the momentum has yet to dissipate. The feeling remains that the drop of about $100 per ounce from that all-time high was simply a reaction to the overbuying of the metal. According to Bloomberg, the price of gold could decline to $1,700 per ounce in the coming weeks, although it is believed that price momentum will resume shortly thereafter, and the metal will approach and likely surpass the psychologically significant level of $2,000. Supporting this forecast is Ron William, a technical strategist at MIG Bank, who said that the spike of gold to its record high pushed it to “overbought” levels, and that gold could slip down to $1,670 by October. A Commerzbank AG analysis illustrates that if the metal dips as low as $1,650, it would reach a strong support level that could provide a boost as far as $2,000.
Eastern hopes
With considerable attention given to the struggles of the US and eurozone, many have insisted that China’s economy remains balanced and strong. However, the global economy is so complex and intertwined that it will eventually affect conditions in China as well. The IMF has reduced its China growth estimates for 2011 and 2012, revising the former down to 9.5 percent from 9.6 percent, while 2012 estimates were dropped from an initial consensus of 9.5 percent to 9.0 percent.
The IMF insisted that a stronger Yuan would dramatically help to stabilise the Chinese economy and successfully contain inflation. In addition, they said that in order to rebalance the global economy, it is pivotal that China promotes domestic demand, as a result of a decrease in demand across the world: “In countries with current-account surpluses and rising foreign-exchange reserves, a stronger exchange rate, combined with structural reforms, would raise domestic purchasing power and allow external rebalancing, while also containing inflation pressure.” With demand for Chinese exports declining across the world, domestic demand becomes extremely important to the stability of Chinese economic activity. China must restore strength to its currency, if it is to avoid a drop in its growth prospects.
Sterling stagnation
With events from Europe and the US attracting much of the public’s attention, the UK has managed to largely stay out of the economic headlines as of late. This is not to say that conditions are better: in fact, the escalating economic hardships in Europe could hinder UK growth prospects. The country fell into a recession around the spring of 2008, and although the situation has improved since, the country has been unable to completely recover. Growth slowed during the last quarter of 2010, with GDP dropping 0.5 percent; 2011 Q1 saw an increase of 0.5 percent, before slowing again to 0.2 percent in the second quarter.
Another factor stalling growth is the introduction of tax reforms. VAT rose to 20 percent this year, while additional modifications were implemented to national insurance and income taxes in April, which supported low-income individuals while hurting middle to high-income employees. The newly introduced tax burdens are impairing consumers’ ability to increase spending, thereby limiting the pace of growth in the country. Demand for goods and services has also been impaired by pay freezes, instituted by companies struggling to survive the current tumultuous economic conditions.
The underlying theme for individuals and companies alike is restoring order to their finances. Rather than continuing to spend in high volumes, more focus has been shifted toward decreasing debt levels. While this is a positive trend for long-term economic health, it is detrimental to the UK’s ability to improve growth. Inflation concerns are currently at an alarming level, and fears of stagnation are increasing as well. Stagnation takes place when growth slows considerably, while inflation remains high. This scenario presents a challenge to a central bank, since the decision becomes whether to raise interest rates to stem inflation, risking further deterioration of the growth rate.
