Global outlook brighter, but terror fears persist

The outlook for the global economy is improving, although concerns are emerging about prospects for the United States and the eurozone, the Organisation for Economic Cooperation and Development (OECD) said this week.

The International Monetary Fund (IMF) last week also gave an upbeat assessment of the outlook for financial markets, while highlighting the threat of a renewed al-Qaeda terror campaign and the dollar’s dependence on record purchases by Asian central banks.

And the Bank of Japan (BoJ) delivered an upbeat economic assessment, saying Japan was showing signs of shrugging off its long-running recession.

The OECD said its “early warning’’ indicator, which looks at the world’s top 30 economies, was moving forward and that “continued expansion lies ahead in the OECD area’‘.

The Paris-based think-tank warned, however, that “February data signal slightly weakening performance in the US and the euro area, particularly in Germany’‘.

In Tokyo, the BoJ said the economic recovery was now being helped by a pick-up in domestic demand, which had been depressed — in part because price deflation had caused consumers to delay making purchases until goods became cheaper.

The economy’s recovery was seen as depending on the performance of Japan’s car, electronics and machinery exporters. The BoJ has spent massive amounts on foreign exchanges in recent months to prevent an appreciation of its currency against the dollar harming the export trade.

The BoJ suggested, however, that the move was a move towards a broader-based recovery. “Japan’s economy continues to recover gradually, and domestic demand is becoming firmer,’’ it said.

The country has not yet shaken off deflation, with the central bank forecasting that consumer prices will continue to fall slightly on a year-on-year basis.

Business sentiment continued to improve, the BoJ said, with confidence beginning to spread beyond the export sector.
“Although firms are continuing to restrain labour costs, increases in production and corporate profits are expected to have positive effects on employment and income conditions.’’ Unemployment is around the 5% level — high, measured against historical Japanese standards.

Despite the improving outlook for the economy, the Japanese stock market — which had been at its highest for almost three years earlier in the week — fell 1,57%. Dealers said sentiment was overshadowed by worries about the fate of the three civilians being held hostage in Iraq.

Airline and travel companies were among the hardest hit, on fears that security concerns would see a decline in demand for their services.

In its biannual global stability report, the IMF warned that a precipitous fall in the dollar could cause US interest rates to rise sharply, triggering a run on global bond markets.

If foreign investors lost their appetite for US assets, downward pressure on the dollar would intensify, triggering an increase in bond yields, the IMF said. “At any sign of that risk materialising, foreign investors could demand a risk premium on dollar assets, including pushing bond yields higher and with more volatility than current market expectations.’‘

The favourable outlook for markets would also be threatened if investors took fright because of more attacks like the March 11 Madrid train bombs that killed nearly 200 people.

“It is clear that if there were more incidents along the lines of Madrid, or worse than that, it would have an impact on the real economy, consumer confidence would be hit,’’ said Gerd Hausler, the IMF’s director of international capital markets.

The solution is an “orderly reduction’’ in the US current account deficit, now running at a record $500-billion a year, the IMF said, urging a “strong and sustained cooperative effort’’ from the world’s leading economies to reduce global imbalances.

Despite its concerns over the dollar and terrorism, the IMF said markets were currently enjoying a “sweet spot’‘, which had allowed financial institutions to rebuild stretched balance sheets. Economic activity had returned, while inflation remained under control, leading to very low interest rates.

While investors had become accustomed to low rates, the IMF warned that, should a dollar sell-off trigger a rebound in bond yields, investors who had borrowed short-term at low rates in order to buy up higher-yielding, long-dated debt could be in trouble.

The IMF drew a parallel with the last big shakeout in global bond markets in 1994, when investors were taken by surprise by the speed at which the US Federal Reserve pushed up borrowing costs. The resulting bond sell-off was exacerbated by the exposed position of investors who had borrowed in the US to invest in higher yielding European debt.

Investors have already had a taste of the kind of volatility that could hit bond markets, following recent surprisingly robust US jobless figures. Long-term borrowing rates shot up almost a quarter of a percentage point, as traders bet on earlier-than-expected US interest rates rises.

The IMF said the risks of a shakeout were exacerbated by so-called “herding behaviour’‘, where an investor buys a risky asset that he does not fully understand but which has performed well over the past year. This can lead to certain small and illiquid asset classes becoming overvalued.

Terrorism remains a continuing risk factor to financial markets, the agency said. If the markets begin to believe that multiple terrorist attacks are likely, they could lose their appetite for risk and cause a downturn in global markets. — Â

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