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Four market risks… and why they might be overdone

19 October 2014

Headwinds to global growth have exacerbated market falls in recent weeks, but Capital Economics says many of the factors behind this are not as big a risk as some fear.

By Gary Jackson,

News Editor, FE Trustnet

The past few weeks have seen renewed turbulence in the markets as investors focused on a number of economic headwinds, but some analysts believe these worries could be overdone.

Last week the FTSE 100 suffered its worst one-day fall in 16 months, shedding 2.8 per cent and closing at 6,211.64 points on Wednesday after weak US retail sales dented investor sentiment.

Most equity indices fell last week as clouds gathered over the outlook for global growth.

Performance of indices over 3 months

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Source: FE Analytics

While the sell-off has been significant - at the time of writing, the FTSE had fallen 10 per cent over one month - many of the issues seen to be driving the falls have been in the market’s eye line for some time.

However, macroeconomic consultancy Capital Economics has analysed four of these drivers and suggested reasons why their threat may be overdone.


Eurozone weakness

Worries about the health of the eurozone have re-emerged as a source of market turmoil, as fears mount that the single currency bloc is heading into a triple-dip recession and a deflationary spiral.

Capital Economics sees the current state of the eurozone as a real threat to stability, but reminds that the European Central Bank (ECB) has still room to ease its policy further if current efforts fail to alleviate the region’s problems.

The most recent figures from Eurostat, the statistical office of the European Union, show eurozone annual inflation fell to 0.3 per cent in September, while economic growth was broadly flat in the second quarter.

The ECB cut interest rates last month and announced an ambitious stimulus programme in a bid to support growth and inflation.

However, markets have fallen in recent weeks over concern that the central bank’s efforts will not be enough to prevent serious economic malaise.


Performance of indices over 1yr

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Source: FE Analytics

Attention has turned to Germany, where Berlin recently slashed its 2014 and 2015 growth forecasts to 1.2 per cent - down from 1.8 per cent and 2 per cent, respectively.

The eurozone’s largest economy has been hit with slowing industrial output and falling business confidence, exacerbating fears that the region is heading into a renewed slump.

Julian Jessop, chief global economist at Capital Economics, agrees this concern could affect the market for some time to come: “There are a number of ways in which the deep-rooted problems in the eurozone could play out.”

“The single currency could muddle through, as it has for many years. But our feeling is that more extreme outcomes are still on the cards, including an eventual break-up. In any event, it is hard to see any solution that does not involve additional easing by the ECB and further euro weakness in the coming months.”


Oil price collapse

However, the consultancy is less worried by the prospect of a collapse in the oil price, which has slumped more than 20 per cent over the past year.

A number of reasons have been suggested for the plunge, including a shift in market sentiment as fears mount over the health of global economic growth and the impact of geo-political tensions in the Middle East and eastern Europe.

Some members of the Opec oil producers' cartel are arguing for production cuts that would help move the oil price back towards the $100-a-barrel mark, although there have been reports that Saudi Arabia would be unwilling to push for a cut even if prices dropped to $80.

Performance of index over 1yr

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Source: FE Analytics

Jessop said: “This slump is partly a reflection of weak demand from Europe and China, but it is mainly due to booming supply and has been compounded by dollar strength and panic selling.”

“As such, the collapse in oil prices overstates the weakness of world economy. And whatever the reasons for the fall, lower energy costs should actually help to kick-start global growth.”

Capital Economics expect the price of Brent to move from its current $88 a barrel to around $93, before trending down over the coming two years to $85 by the end of 2015 and $80 by 2016’s close.



Emerging markets slowdown

Concerns over the slowing pace of growth in emerging economies, especially China, have been cited as one of the reasons behind this year’s shakiness in equity markets but Capital Economics points out that “this is essentially old news”.

“The bulk of this slowdown took place between 2010 and 2012, since when growth has actually been relatively stable,” Jessop said.

“It is no coincidence that 2010 to 2012 also saw the biggest falls in the prices of industrial metals – a more reliable bellwether of the global economy than oil – since when these prices have been relatively stable too.”

Over 10 years the MSCI Emerging Markets Index has returned 203.37 per cent, FE Analytics shows, vastly outperforming the 110.99 per cent gain in the developed market-focused MSCI World.

However, concerns over slowing growth as well as the withdrawal of quantitative easing has seen emerging market equities lose 2.08 per cent over the past year against the MSCI World’s 4.59 per cent.

Performance of indices over 1yr

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Source: FE Analytics

Jessop concedes that China’s growth may have weakened further in the third quarter of 2014 and may even dip below the closely watched 7 per cent mark.

However, he suggests that this slower rate may be healthier than China’s breakneck pace of the past and, given the larger size of the economy, the actual increases in activity will be larger even if annual growth rates are slower.


Geo-political risks

It seems like no term has been more used by the financial press this year than ‘geo-political risk’.

The tension between Russia and Ukraine, the spread of Islamic State in the Middle East, the recent protests in Hong Kong and the Ebola outbreak in west Africa have led to fear of continued instability and market jitters.

Jessop said: “We think the bulk of these worries are overdone, but again it could be Europe that provides the biggest shocks.”

“Political developments in the UK and France are worth watching especially closely. In particular, the rise of UKIP could force an early referendum on the UK’s membership of the EU, with any talk of British exit sending shockwaves across the region.”


However, the economist says market volatility looks set to continue in the months ahead - even if investors become more confident in their outlook for global growth.

“Even if we are right that global growth fears soon start to fade – helped if necessary by additional stimulus in the eurozone and China – the focus could simply return to the prospects of an earlier tightening of monetary policy in the US,” Jessop concluded.

“This should see Treasury yields resume their upward trend and keep market volatility generally high.”

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