The AMP’s chief economist and strategist, Dr Shane Oliver updates his Wall of Worry report from may, which was pushed a little higher yesterday with the US Federal Reserve cutting its 2011 and 2012 growth forecast for the US and lifting its estimates for inflation and unemployment.
Back in May we became concerned the worry list facing investors – including European debt, China and softer global data generally – was getting more serious and shares were vulnerable to more weakness in the months ahead.
This has indeed been the case.
From their April highs to recent lows, global share markets have had a correction of 7%, but Australian shares fell over 10% on added concerns about rising interest rates and the strong $A.
However, we also thought the current rough patch would prove temporary and, as we saw last year after a similar rough patch, confidence in the global recovery and hence shares would recover into year end. Is this still justified?
The worry list remains worrying
Over the last month or so the worry list for investors has included a renewed intensification of European debt problems, fears about European Central Bank tightening,
Japan’s return to recession, high oil prices, monetary tightening in China and other emerging countries, slowing growth indicators in the US, the ending of QE2 this month and US debt ceiling negotiations.
With so many balls in the air its little wonder share markets weakened.
At its core, there are effectively three key concerns for markets right now: Greece, the US slowdown and China.
Why all the concern about Greece again?
Greece’s public debt woes first hit the headlines in late 2009.
It received assistance in May last year from the European Union, European Central Bank and IMF.
However, it has run into trouble again in recent months as austerity measures weakened the economy, in turn necessitating more spending cutbacks, which are now meeting intense Greek opposition.
At the same time, Germany in particular has been insisting private investors in Greek debt share in part of the pain by extending the term of loans, which in turn has pushed Greek bond yields to exorbitant levels (e.g. the 10 year bond yield touched almost 18% last week) making it impossible for Greece to rollover private debt as assumed under the original bailout.
Several points are worth noting:
The direct threat to the global economy from a Greek slump is non-existent as it’s less than 0.5% of global GDP.
Rather, the worry is that it if it defaults it might set off a global credit crisis much as Lehman’s failure did in 2008.
French and German banks are the most exposed to Greece with an $US53bn and $US34bn exposure respectively.
This is probably manageable but the real concern is French banks’ $US590bn exposure and German banks’ $US499bn exposure to Ireland, Portugal, Spain and Italy.
An uncontrolled Greek default could lead to a sharp rise in funding costs for these other problem debt countries, making it harder for them to reduce their debts and at the same time lead to a run on exposed banks.
And banks may stop lending to each other as occurred in the GFC.
All of which could lead to another credit freeze and disruptions to global economic activity as occurred after Lehman’s failure.
The situation has been worsened by opposition to bailouts in Germany, conflicting communication from European officials and political compromise in Europe that tends to come only after a market panic.
However, with Germany dropping its requirement that private bond holders be forced to rollover their loans and the Greek Government winning a confidence vote Greece appears to be on track to gain another bailout package.
Nevertheless, there are still more potential upsets along the way including a Greek vote on the austerity measures next week and issues around what sort of voluntary private debt rollover will be required.
What is clear is Europe wants to avoid unleashing a Lehman style event with German Chancellor Merkel stating “We all lived through Lehman Brothers…I don’t want another such threat to emanate from Europe.”
However, while Greece now looks on track for another bailout package, at some point a Greek default looks inevitable.
Despite four years of austerity, its public debt to GDP ratio is projected by the IMF to be 152.5% in 2014, which will be higher than the 127% it was at when it ran into trouble in the first place in 2009.
Europe is likely to continue trying to do all it can to delay default until Spain and Italy are in better shape and a default can be better managed in terms of its impact on the European banking system.
This suggests that whether it’s Greece, Ireland, Portugal, Spain or Italy – European sovereign debt problems will be a periodic source of volatility in financial markets for some time to come.
In the short term though, relief looks to be on the way as the can is kicked down the road yet again for Greece.
The US slowdown
While the latest iteration in the Greek debacle has been unnerving markets in the last week or so, a broader issue has been a softening in global economic indicators.
This is most clearly evident in the US. GDP growth slowed to an annualised pace of around 2% in the March quarter, the current quarter isn’t looking a lot better, the ISM manufacturing conditions indicator has fallen sharply with a further fall in prospect this month based on regional manufacturing surveys and the last few months have seen a slowdown in the US labour market.
However, much of the soft patch can
