The euro-zone economy improved much faster than expected in the second quarter of the year. Growth is estimated to have been around the 1% level, the fastest quarterly level for three years; and this has eased the fears about a move into a “double-dip” recession, at least for the moment. But it is a two-speed recovery, with the German economy estimated to have grown by 2.2% during the quarter, the Netherlands economy by 0.9%, and the French economy by 0.6%, but with Spain and Portugal basically unchanged and the Greek economy falling further into recession. With domestic demand weak, it is therefore essential that overseas demand remains buoyant if German exports are going to continue to drive the overall economy forward; but this is now very uncertain, and so growth projections for the rest of this year and for 2011 are still fairly cautious.
However the European Central Bank is maintaining its optimistic view of prospects. Speaking before the latest figures were announced, the chairman, Jean Claude Trichet, argued that the second quarter outturn would be better than expected, that there would also be an encouraging result in the third quarter, and that there was no prospect of a move into a “double-dip” recession.
He also defended the bank’s actions during the recession, suggested that the economy has responded well to those actions, and was anxious to ensure that “perhaps part of the credit could come to the central bank”.
There is an obvious risk that his comments will prove to be premature. Since the latest downgrade in Ireland’s credit rating has provided further evidence that the problems in the European banking system are far from resolved, and that the threat of sovereign debt defaults remains. It is not surprising therefore that markets have been unable to resist the downwards pressure despite the relatively good corporate results from European companies.
The UK market has also fallen sharply over the past month. The UK economy is currently performing better than expected, with consumer spending holding up well so far; and the markets are continuing to give the latest measures by the new UK government to reduce the fiscal deficit the benefit of the doubt. But there are fears that those austerity measures with have a significant effect on growth in the second half of the year, and into 2011, and that corporate activity will be badly affected. The mood amongst investors has therefore become much more cautious.
The latest news on the UK economy has been encouraging. The Office of National Statistics has recently estimated that retail sales volumes were 1.1% higher in July than in the previous month, and 1.3% higher than in July last year, the strongest monthly gain since February; unemployment remains much lower than might have been expected; the latest Purchasing Manager’s index for July confirms that manufacturing activity is continuing to expand; and exports also appear to strong.
There are weaknesses in the housing sector, and apparently some loss of momentum in the services sector, and bank lending remains low; but overall there are hopes that growth in the current quarter will be at reasonable levels. But there are already indications that the austerity measures announced by the government are beginning to have an effect on activity, and so the situation remains very uncertain.
This uncertainty is reflected in the minutes of the latest meeting of the Monetary Policy Committee of the Bank of England. They state that the economy is “on a knife-edge”, with “substantial risks” of a relapse balanced against signs of “gathering momentum” in the recovery. This uncertainty persuaded the majority of the members of the committee that policy should remain unchanged for the present; but the minutes indicated that “the risks were substantial, and that members stood ready to respond in either direction as the balance of risks evolved”. The subsequent Inflation Report from the bank was also a cautious document, with growth forecasts revised lower, primarily because of the expected effects of the austerity measures, and with the governor of the bank, Mervyn King, stressing the need for “continuing monetary stimulus” in the face of the “choppy recovery”. Interest rates are therefore likely to remain low for some considerable time, despite the fact that the inflation rate is well above the bank’s target rate, and so monetary policy will continue to be supportive. But will this be enough to justify the present market level? Global growing is slowing, and this will add to the downward pressures on the economy resulting from the austerity measures as they are introduced. The odds therefore seem to favour further UK market weakness in the near-term, even though we believe that the economic recovery will continue, and eventually lead to higher equity prices.
The Japanese market has also moved lower over the past month. Recent figures have shown that economic growth in Japan slowed very sharply in the second quarter of the year because of weak domestic demand and falling exports; and as a result China has replaced Japan as the world’s second largest economy for the first time. Growth is estimated to have been at a 0.4% annualised rate in the second quarter, after a 4.4% rate in the first three months of the year, and this has increased the fears that the country may once again be slipping back into recession. The dependence on exports has been an important adverse factor, as overseas markets have weakened, and this has encouraged speculation that the Bank of Japan will be forced to intervene in the currency markets to prevent further appreciation of the yen; but even this might not be enough to avoid a recession. In this situation, it is particularly unfortunate that an impasse exists at the political level that is making it extremely difficult for the government to take effective action. The background situation therefore remains very disappointing, and the weakness in the equity market looks set to continue.
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