Equity markets sing a different tune from the IMF

Global investor sentiment is now not only split down the middle, but the split is getting deeper and wider. The optimists and pessimists are further apart than ever. Those who insist “the worst is behind us” are clashing with those who fear we could face another big lurch. I’ve noticed lately that such forecast polarization is often apparent even within individuals. Seasoned financial professionals flit from bullish to bearish, from “risk on” to “risk off”, sometimes within the same conversation. There is profound uncertainty, with recent share price rises seeming to compound the sense of confusion, rather than providing “relief”.

The outlook for the world economy – at least the Western world – seems grim. The International Monetary Fund’s newly updated World Economic Outlook says global growth will be significantly weaker than previously thought, with the eurozone as a whole likely to go into recession, even if another “Lehman moment” is avoided.

The world economy will expand by 3.3pc in 2012, says the IMF, well below the 4pc estimate it made last September. This downgrade is driven largely by a 1.6 percentage point drop in the Fund’s forecast for the eurozone economy, which it now expects to shrink 0.5pc this year – again, even without another “big one”. Italy and Spain will contract by 2.2pc and 1.7pc respectively, says the IMF, due to austerity measures, high debt costs and an on-going credit crunch.

The Fund’s view on the US hasn’t changed since September, with 1.8pc growth predicted in 2012. America will pull away from a eurozone slump, says the IMF – once more, so long as a disorderly “break-up” of monetary union is avoided. If countries do start falling out of the single currency, though, the IMF foresees the eurozone economy contracting by a massive 4.5pc, worse than the region’s 4.1pc “post-Lehman” GDP collapse in 2009.

In this latest report, the Fund has joined the World Bank in predicting that a “euroquake”, were it to happen, would prompt another global recession, on the scale of that which followed Lehman. Back then, the world economy recoiled by 0.6pc, the first such global contraction in decades.

“The most immediate risk,” the IMF says, “is the intensification of the adverse feedback loops between sovereign and bank funding pressures in the euro area. The Fund goes on to conclude: “Financial conditions have deteriorated, growth prospects have dimmed, and downside risks have escalated”.

The IMF, lest we forget, is the world’s most important financial watchdog. Its forecasts are often wrong, of course, as are those of every economic research body that has ever existed and ever will exist. But the Fund is no economic scribbler, shooting numbers from the hip. Its forecasts are generally credible, smack in the middle of mainstream economic thinking. Yet it’s saying a eurozone break-up could happen, while describing the implications of such an event in lurid terms.

What has really polarized opinion lately, though, is that despite all the economic gloom, and widely-held concerns of systemic danger, global stocks have anyway rallied defiantly throughout January and are showing signs of building up a head of steam.

In the US, the Dow Jones benchmark index has been on a five-week rampage and is now at a 3.5-year high. As the Facebook IPO gets going, the Nasdaq has also soared. This tech-stock index is up 20pc since mid-September, now at its highest level since the late 1990s “internet boom”. On this side of the pond, the Bloomberg Europe-500 index has gained a very respectable 8pc so far during 2012 and the FTSE-100 is up a handy 6pc.

This storming start to the year was topped by a report published on Friday that showed the US economy created far more jobs than expected in January, with unemployment down to 8.3pc, a three-year low. That sent the markets wild, to such an extent that America’s bellwether S&P500 index has now registered its strongest start to any year since 1987.

It must be said, though, that this shift in market sentiment wasn’t sparked by any improvement in the economic fundamentals. What we’re seeing in the macro numbers, on the contrary, is evidence of further European economic deceleration and a rising chance of recession in some of the world’s biggest economies.

What cause this rally, of course, was very explicit reassurances that the “big four” global central banks (the US Federal Reserve, the Bank of Japan, the Bank of England and, increasingly, the European Central Bank) will keep providing practically unlimited funds at interest rates close to zero.

At the end of last year, the ECB pumped the best part of half a trillion euros of credits into the eurozone’s addled banking system. The markets expect that, now the rubicon has been crossed, and German Chancellor Angela Merkel “finally gets it”, there will be much, much more to come. This outcome is now not so much a working assumption among traders, but more an article of faith. Awkward questions about complex political issues, the pressure Merkel is under from an increasingly irate Parliament and electorate, the long-term sustainability of “quantitative easing”, the possibility of a bond market eruption, are waved away as indulgent, as if even to pose them is to will the entire edifice to collapse.

Across all global market, though, the reality is that Europe remains the wild card. The Greek debt swap talks, which continue this weekend, are said to be “close to conclusion”. Again. But there is the growing possibility of the ECB taking a “haircut” on its €40bn of Greek bonds in order to give Athens a financial break, given that many of the private sector creditors, having previously said they agreed to take a hit too, are now refusing. That will raise political tensions even further. The ambitious German Finance Minister Wolfgang Schaeuble is certainly cranking up the domestic pressure, insisting that he and his fellow citizens “can’t keep paying into a bottomless pit.”

As eurozone sovereign bond markets have been hosed down with public money in recent weeks, courtesy of the ECB’s Long Term Refinancing Operation, yields have fallen. This has encouraged market hopes that “the worst is over”, or that we are entering, at least, a period of calm. I sincerely hope so. As a financial markets professional, I must say that a period of calm sounds very appealing indeed.

Yet the screws are now being turned on a Greek government that looks increasingly unable to meet its obligations with respect to promised fiscal consolidation, as its economy and tax base shrinks. And while Italian borrowing costs have fallen from alarming pre-Christmas levels, they remain well above 5pc. The country’s impending expected GDP contraction means tough questions will surely be asked once more.

Economic forecasting isn’t a science. It is, in fact, a deeply imprecise and rather grubby art. Politics always looms large in the formation of any high-profile projections. Yes, the IMF, under former French Finance Minister Christine Lagarde, is keen to bounce Germany into monetary surrender, so preserving the eurozone. Forecasting economic Armageddon is one way to try to do that. The White House, too, wants Merkel’s capitulation to be complete, to get the markets back in good shape in the run up to the November Presidential election. No wonder the IMF’s latest missive was so gory.

It remains true, though, that while “stabilization” is possible, and “muddle through” may even be the most likely outcome, a fresh escalation in this ghastly crisis is also a very real possibility. Investors should be mindful of that.


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