George Magnus is the author of The Age of Ageing - how demographics are changing the global economy and our world, and Uprising: will emerging markets shape or shake the world? His previous positions include Chief International Economist at UBS, Head of Fixed Income Research and then Chief Economist at SG Warburg, Chief International Economist at Chase Securities, Senior Financial Economist and then Head of Economics (EMEA region) at Bank of America, European Economist at Lloyds Bank International, and Economics Writer at the Central Office of Information. He received an MSc Econ from the School of Oriental and African Studies, London, and taught Economics at both the Central London Polytechnic and the University of Illinois.
There is no question that financial markets have received a major lift following three key developments since the end of 2011: The European banking system has been thrown a lifeline, Greece defaulted on its debt without causing panic, and the US is continuing its journey to an economic recovery. Investors may have more reasons to have a spring in their step, but that doesn’t mean they can afford to be less watchful of the road ahead.
Huge risks remain, not least because economic prospects following major debt crises generally tend to be erratic and volatile. Locally, political outcomes and behavior are crucial to economic outcomes. Globally, the continuing risk of tensions in the Middle East threatens higher oil prices, which could derail the world economy, sooner or later. Let’s look at these issues one by one.
Thirst for reforms
First, the European Central Bank (ECB) has provided around EUR 1.0 trillion of three-year loans (long-term refinancing operations or LTROs) to European banks in order to strengthen the funding position of the banking system. In effect, this has removed the risk of a severe banking crisis, and almost certainly convinced investors that the economic contraction expected in Europe this year will be less severe than they had feared.
However, this liquidity injection cannot substitute for the absence of the structural reforms needed to restore growth, competitiveness and fiscal sustainability. Eurozone banks have become increasingly dependent on the ECB, while the passing of the crisis per se is allowing banks and governments to back away from the more urgent reforms they need to embrace to overcome liquidity and solvency issues.
A still-fragile union
Second, Greece’s debt restructuring was more or less successfully concluded, removing the immediate threat of a disorderly default and the country’s possible exit from the Eurozone. Though the restructuring may have bought time, Greece looks likely to have to endure austerity and receive official support for the foreseeable future. A further default seems likely. More immediately, elections are scheduled in May, and these may generate new uncertainty about the stability of the Eurozone.
France is also due to elect a new president this spring, and polls suggest victory for the Socialist Party’s Francois Hollande, whose idea of European budgetary integration differs from the sort championed by Germany. Ireland will hold a referendum over the new Eurozone “fiscal compact” by June, and its own attempt at restructuring its debt has become a highly sensitive issue. Spain is also struggling again to sustain investor confidence as it seeks to impose large budget cuts. Underlying these events is the delicate subject of sovereignty, where member states all have issues over the ceding of important rights to national self-determination, a requirement for much greater fiscal and political integration.
Make hay while the sun shines
Third, the US economy has continued to surprise. At the time of writing, economic data showed not only a drop in the unemployment rate but also increases in exports, car sales and bank-lending to companies, as well as improvements in the beleaguered housing sector. The Federal Reserve’s language to assess the economy has changed a little to reflect the achievement of moderate growth. Some investors even fear that the Fed might raise interest rates later this year.
It is appropriate to ‘make hay’ in response to the economic news because the US seems to be making some headway with its rebalancing agenda. But it is also important not to get carried away. An unusually warm winter may have contributed to better economic readings, US households are still in the process of deleveraging, and new fiscal drag will occur, one way or another, after the presidential and congressional elections in November.
Politics and oil
The trouble is that American fiscal policy is both messy and almost impossible to predict, not least because we don’t know what the political settings will be after November, and also because so much of American budgetary policy is temporary. There are 42 tax provisions, for example, including the Bush tax cuts and the payroll tax cut and excise duties on gasoline, which expire this year. So it’s almost impossible to say what the US fiscal position will be in 2013.
Politics also plays a large part in predicting the oil price this year. If oil prices are rising because demand is going up, then there will come a time when the cumulative increase could have a significant depressing effect as well, but I don’t think we are there yet. As a guesstimate, oil prices would probably have to go up to about USD 135 – 140 a barrel before the broadly beneficial effects of higher demand would actually be counterbalanced by higher costs.
It does make a difference if oil prices are going up because people are worried about the risk of, say, Iranian ships blocking the Straits of Hormuz. This is rather unlikely to happen this year, particularly with the US presidential election looming. If it does occur, any price increases driven by speculative purchases due to worries of a runaway breakdown of the Iranian tension may not last very long. In other words, we are not in 'crisis mode' yet so far as the price of oil itself is concerned.What then of Asia? Here too, politics are crucial. China will undergo a change in leadership later this year against an intriguing backdrop. The economy is decelerating as the real estate market cools and exports suffer from the global slowdown. And the leadership change is taking place with a vigorous debate within the Communist Party. This debate is about the choices between the state capitalist model that have brought China to where it is today, and a more liberal version of capitalism based around greater social equity, transparency. This is ultimately about whether the party has the pragmatism and the political appetite to lose control – and the corollary, of course, is what happens if it doesn’t?
UBS Perspectives thanks George Magnus, Senior Economic Advisor to UBS Investment Bank, for this contribution. UBS Investment Bank maintains an independent forecast that may not coincide with UBS Wealth Management’s. For the latest Wealth Management house views and investment strategy, please refer to the UBS CIO Monthly Letter, available to all clients in Singapore and Hong Kong. For more details, please contact your UBS Client Advisor.