Friday, November 4, 2011

Deconstructing the "wall of worry"

“Wall of worry” has become the euphemism for all the things financial markets have been fretting about recently. The wall has many components, let’s call them “bricks”, including recession concerns in Europe and America, and whether China looks set for a hard or soft landing. To continue the wall analogy: while the mortar around some of these bricks is loosening, the foundation stone of the European debt crisis remains firmly in place.

In America the economy is not in recession, but remains in a fragile, debt-constrained recovery. Third quarter GDP growth of 2.5% was bang on market expectations, higher than we were expecting, but unlikely to be repeated soon. In particular consumption was the surprise upside factor in this result, but we don’t expect that strength to continue given it was largely funded out of a decline in the savings rate. The good news was the strength in the parts of the economy we have looked to drive the recovery: exports and business investment.


Looking ahead we expect growth to be lower in the fourth quarter at an annual rate of around 1.5%. The October ISM manufacturing index declined although the make-up was positive, especially the rise in the new orders index. The medium-term outlook will continue to be constrained by the weak housing market, still slow improvement in the labour market (jobs and wages), household deleveraging and fiscal consolidation.

Indeed the politics of fiscal policy will remain front-and-centre in America. The passage of President Obama’s stimulus plan looks uncertain and the development of a medium-term fiscal consolidation plan will be politically fraught, let alone the implementation of a plan that must deal with the unsustainability of some key US social programs.

China still appears to be heading for a soft landing. Property prices and activity have been slowing this year, driven by aggressive tightening measures by the authorities. There is some concern this slowing could turn to a collapse, but we don’t see this as likely. The China October PMI manufacturing index came in just over the 50 benchmark. This was weaker than expected, but in areas that were unsurprising (exports). GDP growth has slowed to 9.1% in the third quarter and we believe growth will come in around 9% for the full year. We’ve got 8.5% pencilled in for next year as the impact of the recent tightening in monetary policy continues to flow through the real economy.

The good news is that China has room to move on both monetary and fiscal policy. Inflation is at 6.1% for the year and appears to have passed its peak. We expect China to start loosening monetary settings in the first half of next year, but that could be brought forward if growth looks to be weaker. Authorities have proven agile on switching policy settings when required.

Europe is most likely already in recession. While we expect third quarter GDP to come in mildly positive, partial indicators are pointing to a mild contraction in the fourth quarter. We expect this weakness to be largely centred in the industrial sector. Business confidence and economic activity are being impacted by the uncertainty created by the debt crisis. Low confidence means hiring and investment gets delayed. Today’s cut in interest rates, and a likely further reduction in December, is a positive development, but uncertainty is likely to continue until the debt fear subsides.

Which brings me to the big one – the foundation stone of the wall. We were moderately happy with last week’s Europe debt plan. While it lacked detail, we were pleased that what we believed are essential elements of a sustainable plan were finally part of the conversation: a bigger haircut for Greek bond-holders, bank recapitalisation and a scaling up of the European Financial Stability Fund (EFSF). Seems to us policymakers are now having the right conversation.

But as we said last week, we still need to be wary of the politics. This week’s referendum distraction is an early reminder of that. The fact is there still needs to be a high degree of political will for effective implementation of the program. Italian bond markets were already pricing in a “lack of detail” premium, even before Papandreou announced his intentions for a referendum. At the end of the week markets are breathing a sigh of relief as the referendum appears to be off. But this is unlikely to be the final political twist we will have to endure.