False dawn or risk recovery?

June 15, 2010

Jane Foley is research director at Forex.com. The opinions expressed are her own.-

What began at the start of the year with an acknowledgement from Greece that it had been living way beyond its means soon turned into a more universal re-appraisal of the risks of sovereign default.

After Greece, the bond markets of Spain and Portugal were next to be re-examined.  More recently even the yields spreads of French and Dutch bonds vs German Bunds widened. Investors have shown themselves less inclined to finance the debt of countries which are not prepared to exercise budgetary prudence and governments have been forced to sit up and listen.

The rhetoric of this month’s G-20 meeting made clear that expansionary fiscal policies are off the agenda and that fiscal consolidation has become the new watchword of the majority of G-20 governments. Fiscal austerity clearly has an impact on growth potential and consequently on the market’s attitude towards risky assets.

The program of fiscal consolidation in the UK has just been launched.

Now safely in office the new coalition has been quick to let voters know the awful truth that deep public sector spending cuts are inevitable and will be “felt for decades”.

The UK’s budget deficit/GDP ratio may the worst in the G7, but it is by no means the only sizable industrialised country that has budgetary woes.  Market forecasts suggest the U.S. deficit could be 9 percent of GDP this year, but at least it is likely to perform better in terms of growth.

The Federal Reserve last month revised higher its 2010 growth forecast for the U.S. to 3.2-3.7 percent, the Bloomberg survey indicates a market consensus for U.S. 2010 growth at 3.2 percent compared with 1.1 percent for the Eurozone in 2010 and 1.2 percent for the UK.

The U.S. fiscal repair process may not be fully implemented until next year, but fiscal consolidation in the Eurozone is thematic not just in the periphery but also in many of the core countries.

The process of fiscal repair will weigh on growth in the coming years.  Since the end of April it has been clear that markets have been taking on board the prospects of a prolonged period of relatively slow growth in the industrialised world.

The optimism that fuelled rallies in stocks and other risk assets through the better part of last year came to an abrupt halt in April.  The recovery in growth noted in most developed countries from the middle of 2009 was built around huge fiscal outlays.

The time has come for governments to repair their balance sheets; as Bank of England Governor Mervyn King recently noted the financial crisis is only half way through.

There is a clear logic behind the recent correction lower in stocks and other risk assets.  The obvious question to ask now is whether this correction has further to go or whether it is drawing to a close.

Many of the answers will be found in economic data.  Despite reassurances from Federal Reserve President Bernanke that the (U.S.) economic recovery remains intact, the market will be sceptical about the ability of U.S. growth to accelerate until labour data show a significant improvement.

The impact of May’s disappointing U.S. payrolls number will be difficult to shake off. That said German, Chinese and Japanese economic data recently have been strong suggesting the global recovery is firmly in place.

Clearly, the market has had to adjust lower its exuberant expectations of growth to more moderate levels but it currently seems likely that most countries will avoid double-dip recession and stay on the recovery track.  This suggests that most risk assets should avoid a further sharp collapse from current levels.

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