A Stumbling Recovery

As we settle into 2010 and take stock of recovery in the UK, there are few positives for even the most optimistic of commentators to cling to. Without wishing to toll the bells of doom and gloom, it is becoming increasingly difficult to put a positive spin on the UK’s economic outlook. Whereas there was a point in the latter part of last year when the fears of a credit rating downgrade and double-dip recession were beginning to fade, both now appear to have crept back to the fore. Adding unnecessary pressure, the Conservatives are watching their lead in the polls being steadily eroded, heightening concerns of a hung parliament.

The future for the eurozone recovery also appears to be in the balance. The EU have done a fine job of stalling in recent weeks, reassuring investors that the problems (a clear understatement) in Greece and other peripheral eurozone nations can be brought under control. There are no quick solutions materialising on the horizon just yet though. Greece may say that they do not need a bailout, but they appear to be in a minority on the topic. Developments emerging over the coming months as yet seem unlikely to provide any definitive polices to tackle the fiscal woes hanging over the eurozone. Until the market is assured that debts can be financed, the single currency will continue to suffer.

In a far stronger position in their return to economic stability, the US Federal reserve has already taken steps toward pre-recessionary economic policy. Evidence has pointed to the potential for a strong US recovery, and the Fed has reacted accordingly. The surprise move in February, to raise the Bank’s lending rate by 0.25%, has now heightened expectations that the US may be among the first to increase the base interest rate level from record lows.

Election Unease Building in the UK

For the UK economy, the hurdles to recovery remain as ever-present as they did in late 2009. In the Bank of England’s quarterly Inflation Report on 10 February, little had changed since three months earlier. The real spanner in the works now though is the UK election, which could not have come at a more inconvenient time.

But why would this impinge so dramatically on the economic recovery and indeed on the pound? The market is fearful that the outcome of this year’s election could be a hung parliament. In this scenario it may be tricky for the drastic spending cuts needed to reign in the deficit to be put through parliament.

Some commentators have delved into further speculation. They are suggesting that, should the UK’s deficit not be properly financed, the rating agencies waiting in the wings may cut the country’s AAA credit rating. Inevitably, the pound would then plummet and investment would drop as the cost of borrowing soared. The Bank of England might then be forced to intervene and raise interest rates prematurely in order to stabilise the pound but at the risk of destabilising the fledgling recovery.

Amid this somewhat pessimistic scenario there are a fair few ifs and buts and the reality is that a hung parliament is by no means probable. Despite David Cameron’s best efforts to distinguish the Conservatives’ lead, the polls are unlikely to be telling the whole truth. The last hung parliament in the UK was in 1974, only lasting for six months, and prior to that was the 1929 election. History would suggest that it is an unlikely possibility. Unfortunately, market players will continue to speculate up until the election, which is looking set for June. As we have already seen this year, it only takes a few comments or even rumours to put significant volatility in the markets.

In addition to the election, the UK is continuing to suffer from weak economic fundamentals. Lagging all other G7 nations, the UK economy has emerged from recession, but the growth figure of 0.1% is a long way from convincing. The forecast had been for 0.4%. Although there is certainly a psychological boost to be had from a return to growth, the pressures still remain. Recently data revealed that Germany’s economy returned to stagnation. Such a scenario in the UK would make Mervyn King’s case for extending quantitative easing ever more convincing.

Recent figures have knocked sterling’s recovery prospects further. Sales in January fell at their sharpest rate in one and a half years. Only a day earlier it was revealed that the UK posted its first budget deficit for the month of January since records began in 1993. These numbers hardly endeared investors to the UK economy and have renewed fears that at a time when other central banks are actively starting to tighten policy, the Bank of England could extend emergency measures.

Resolutions Remain Elusive

The situation may be deteriorating in the UK at the moment, but the headline-grabber this year has been Greece. In running a deficit of over four times the limit set out by the EU (3% of GDP), Greece has sent the single currency on a sharp downward spiral in 2010. That Spain, Portugal, and Ireland are in not too dissimilar a position has compounded the euro’s depreciation. However, should these countries begin the aggressive fiscal tightening that is perceived as necessary they are likely to plunge their economies back into recession. All this begs the question, how will the European Central Bank (ECB) respond?

Recently the ECB has done a good job of stalling and stemming the heavy selling of eurozone assets. However, policy needs to be set that appeases all 16 nations of the eurozone, nations that are evidently in varying stages of recovery. The lingering question mark over a possible bailout plan also remains to be satisfactorily answered. Until a concise plan is detailed, the market is bound to remain sceptical. The German Chancellor, Angela Merkel, has said a solution to the Greek crisis is the “core element” in re-establishing confidence. However Germany, presumed by default to be at the centre of any support directed toward Greece, may now be focusing on getting its own economy back in shape before aiding Greece. The questions lingering over the eurozone will remain at the heart of market movements.

The volatility that the Greece saga has created, and will continue to create, could leave companies hugely exposed to sharp currency swings. If we have learnt anything in recent months, it’s that predicting market movements is getting increasingly difficult. With a resolution to the eurozone indebted still up in the air, vigilance will be paramount to prevent the possibility of being left exposed.

Taking Steps to Unwind Emergency Policy

By contrast to both the UK and the EU, the US economy has made an encouraging start to 2010, which has been reflected in the currency. Since December 2009, the US dollar has gained some 7% against the pound and 10% against the euro. This strength has stemmed from both a notable run of strong figures as well as the dollar’s traditional safe haven status.

Contrary to expectations, key US employment figures have shown improvement, with the overall jobless figure now declining from the 10% level. Economic growth is also outpacing other G7 nations. In response the Fed has pushed up its emergency lending rate, a clear step towards normalising policy. For now, Fed officials appear to be sticking by their policy that rates will remain low “for an extended period,” in order to play down speculation. However, the market is in little doubt that the decision marks a decisive move away from emergency policy. In response, the strength that the US dollar had at the end of last year is beginning to gather momentum. US dollar sellers are enjoying near 10-month highs. However, for those buying, the near- and even medium-term outlook inspires little hope.

That the world’s largest economy is showing strong signs of recovery can only be positive, although the White House’s controversial proposal to impose regulations on the banking sector is causing uncertainty in the current climate. In a bid to prevent major banks taking the stance of “we’re too big to fail,” Obama announced plans to separate the investment and retail wings of US banks. I think it is fair to say that such a bill will come across strong resistance should it even reach the House of Representatives. However, with the future of the US banking model uncertain, there are risks to the stability of the economic recovery that will need to be watched closely. As yet, we can only speculate upon the impact such a move could have on the markets. However, developments on the matter should be cause for concern, given the significant impact on the strength of the US dollar.

China’s Role

Perhaps showing signs of endangering the recovery, China is also starting to tighten its policies. Stronger than expected levels of growth led the Central Bank of China to raise the reserve minimum that banks must hold in deposit. Consequently the high level of demand from China that has driven export markets around the world may slow. The curb on lending has caused stirs in the market, with the investors aware of the negative impact it could have on growth in emerging economies. Higher-risk currencies are extremely sensitive to developments in China.

Perhaps of more interest though, over the coming year, will be the way in which the Chinese Central Bank reacts to pressures to raise the peg on its currency. Currently, the yuan is considered by most to be grossly undervalued. It is more a matter of when rather than if they bow to pressures to raise the peg. As pressures mount, market volatility will rise another notch as the impact on the global economy is realised.


As we move through 2010, market volatility will remain as economies emerge from the downturn in various levels of recovery. Emergency measures will slowly be unwound, however, as indicators suggest that interest rate rises, outside of Australia, will remain at record lows, at least until the final quarter of the year. There are significant difficulties to be faced and a significant number of commentators that believe a double-dip recession is still the most likely course. For the UK and the eurozone in particular the challenges remain prevalent, and on current evidence the tight conditions will be with us for some time.


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