Following a tough third quarter for world markets and escalating problems in the eurozone, Philip Lawlor looks at where we go from here.
World markets were volatile in the third quarter of 2011, as they struggled to contend with two powerful and simultaneous headwinds.
Structural headwinds
The first was a rapid decline in economic momentum in both the US and Europe. Confirmation of this came when the International Monetary Fund (IMF) reduced its growth estimates for advanced economies from 2.2% to 1.6% for 2011 and from 2.6% to 1.9% for 2012.
The rapid decline in US, UK and German bond yields to 60-year lows is also a powerful indicator that developed economies are recalibrating to a much lower nominal gross domestic product (GDP) growth trajectory (the 'New Normal').
The second major headwind, which has increasingly preoccupied the markets, is the marked escalation in the eurozone debt crisis. The shift in focus to Italian solvency, combined with an inadequate political and leadership response to the eurozone crisis, has raised legitimate concerns over the future of the euro.
The systemic risks posed by the potential decline of the euro are global in nature and have contributed to the 'risk-off' positioning of markets and increased tension in the interbank market.
The eurozone remains extremely vulnerable to further pulses of tension as growth slows in 2012 and sovereign solvency risks increase correspondingly. The New Normal lower nominal growth trajectory continues to exert pressure on solvency arithmetic, but also imposes significant operating leverage risk to earnings growth forecasts.
UK economy
The IMF and the Organisation for Economic Co-operation and Development have reduced their 2012 growth estimates from 2.3% to 1.6%. This has raised further questions over the need to stimulate the economy.
Despite an energy-led surge in the Consumer Prices Index and the Retail Price Index to 5.2% and 5.6% respectively, the Monetary Policy Committee (MPC) voted unanimously to kick-start a second round of quantitative easing (QE) in October. The MPC justified this by referring to the underlying weakness of the UK economy and the vulnerability of the banking system to potential eurozone bond defaults and bail-outs.
The parlous state of the UK economy was emphasised by GDP data that showed that the decline in output in 2008/09 was the deepest contraction since the 1930s. Three and a half years after the recession, the UK economy is still 4% below prior peak levels.
What next?
With a weak labour market, real disposable income is likely to remain negative for several more months and this supports Mervyn King's view that inflationary expectations are not rising and domestically generated inflation is 'almost zero'. Although at some stage in 2012 disposable income will be boosted by declines in inflation, the MPC is likely to expand the scale of QE in 2012 to address the weakness in underlying demand.
The agenda is now shifting towards whether QE should be used in a more holistic way. For instance, Adam Posen on the MPC has warned of the need to counter "policy defeatism" and to use QE to provide credit to SMEs directly, circumventing the banking sector.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
We operate a free-to-view policy, asking only that you register in order to read all of our content. Please login or register to view the rest of this article.