Financial Market Update

This Current Market Trend report is brought to you by Dr Gerard Lyons; Chief Economist at Standard Chartered Bank. The following is his insight for the year ahead.

Twelve months ago, the financial crisis and the collapse in demand and trade justified aggressive global policy action. The combination of liquidity provision, low interest rates, tax cuts and increased government spending provided the escape route the world economy needed.

What next? One of the many lessons of recent years is that if something does not happen immediately it does not mean it will not happen at all.  This was evident with the financial crisis itself, when many warning signs took some time to be proved right. Likewise, it took months for problems in Dubai to materialise and for concerns about the debt picture in Greece to surface. When they did, it was not a surprise. 

The message is that economic fundamentals matter and if something appears unsustainable or out of line with reality then it probably is.

At some stage it will need to correct and the longer it takes, the more severe the correction is likely to be. 

It is important to bear this in mind when discussing the outlook this year. "Recession ends, recovery begins but there is a price to be paid" may be one of the lessons of the year ahead.

That price is either a consequence of the recession itself in terms of bankruptcies or unemployment, or the price of the policy measures needed to get the economy on the road to a recovery which looks likely to be very weak. It is this cost of the policy stimulus that is still unclear and which has continued to unnerve financial markets in the first few months of this year. 

All this needs to be kept in context. The most significant theme shaping the world economy is the shift in the balance of power from the West to the East. This will lead to a New World Order (NWO) with the winners being countries with financial or natural resources or with the ability to compete by adapting and changing. These countries will attract inward investment and enjoy stronger growth. 

Whilst this NWO is the longer-term driver, the world in 2010 will also be shaped by two more immediate factors: the impact of debt and deleveraging in the West and exit strategies following the huge policy stimulus. 

For many international investors the worry is that whilst the world may have escaped a full blown debt and currency crisis so far, it may not be possible to do so in 2010.

Recent years have seen the UK and US added to the list of the usual suspects that financial markets worry about.  

Currency turmoil is another concern and the recent worries within the Eurozone reflect this. To survive, the Eurozone needs to become a full political union. If not, tensions within the Eurozone will mount and continue to reappear.

Whilst concerns so far have hit the Euro, it is Sterling and the Dollar which have both seen large devaluations over the last year or so. With the US and UK both dependent on others to buy their debt, further weakening of the Dollar and Sterling appears inevitable, adding to the devaluation already seen.

Meanwhile, the Chinese are likely to allow their currency to appreciate, particularly as their recovery gathers momentum. They will also come under increased international pressure for a stronger currency. If so, this will be another green light for markets to shift away from the Dollar.

The Euro was a natural beneficiary of Dollar weakness last year. This added to problems that were already apparent in the Eurozone, hitting hard the already weak economies such as Portugal, Ireland, Italy, Greece and Spain. The pressure on the European Central Bank to keep interest rates low, despite the wishes of Germany, will be intense.  

The issue is both the level of debt and the speed at which rising deficits add to this. Markets are worried, largely because of the scale of government borrowing around the world, plus fears that growth may disappoint or inflation rise. 

Growth is the key. The best way to reduce a deficit is strong growth, with low inflation and interest rates. Although recovery is likely to be gradual I think the UK will escape a debt crisis but not all countries will be as lucky. 

The worst case scenario to avoid is a debt trap. This occurs when government debt exceeds 100% of GDP, and when the 'real' rate of interest paid on this debt, that is the rate of interest minus inflation, exceeds a country's rate of economic growth. It is the government version of maxing out on your credit card and then finding it a challenge to pay the monthly interest bill. 

The good news for the UK is that it is some way from a debt trap. Trouble is markets don't wait for these preconditions to be met before worrying. Although the level of UK debt is not particularly high compared with other countries, it is the scale of current budget deficits and the need to fund this from overseas that is the concern. Hence it is vital to retain the confidence of international investors.

This is the main challenge for the UK, particularly as there has been net overseas selling of government bonds during 2009. A combination of worries about inflation, the fiscal outlook and Sterling’s depreciation contributed to this. So too did the reality that there are now more attractive investment opportunities elsewhere in the world such as Asia.

It is a challenge for many countries given the rise in public sector debt. It is therefore vital that the UK continues to keep the markets onside through fiscal consolidation without derailing the recovery. This is not easy. It requires further fiscal tightening post-election to be balanced by the Bank of England keeping interest rates low for some considerable time. 

The good was that action was taken to pull us back from the brink; the bad that this was not done from a position of strength as the government should have run surpluses during the good times and didn’t and the ugly is the consequences. Some fear the ugly will be a downgrade or default. More likely 2010 will show it to be higher taxes and aggressive curbs on public spending. 

We hope that you found Gerard Lyon’s insight to be of interest. For more information regarding the above please contact enquiries@harrodsestates.com 

The Standard Chartered Private Bank is the private banking division of Standard Chartered Bank.

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