Since late last year, a series of positive developments has boosted investor confidence and led to a sharp rally in risky assets, starting with global equities and commodities. Macroeconomic data from the United States improved; blue-chip companies in advanced economies remained highly profitable; China and emerging markets slowed only moderately; and the risk of a disorderly default and/or exit by some members of the eurozone declined.
Moreover, the European Central Bank, under its new president, Mario Draghi, appears willing to do anything necessary to reduce stress on the eurozone’s banking system and governments, as well as to lower interest rates. Central banks in both advanced and emerging economies have provided massive injections of liquidity. Volatility is down, confidence is up, and risk aversion is much lower—for now.
But at least four downside risks are likely to materialize this year, undermining global growth and eventually negatively affecting investor confidence and market valuations of risky assets.
First, the eurozone is in deep recession, especially in the periphery, but now also in the core economies, as the latest data show an output contraction in Germany and France. The credit crunch in the banking system is becoming more severe as banks deleverage by selling assets and rationing credit, exacerbating the downturn.
Meanwhile, not only is fiscal austerity pushing the eurozone periphery into economic free-fall, but the loss of competitiveness there will persist as relief at the waning prospect of disorderly defaults strengthens the euro’s value. To restore competitiveness and growth in these countries, the euro needs to fall toward parity with the U.S. dollar. And, while the risk of a disorderly Greek collapse is now receding, it will re-emerge this year as political instability, civil unrest, and more fiscal austerity turn the Greek recession into a depression.
Second, there is now evidence of weakening performance in China and the rest of Asia. In China, the economic slowdown under way is unmistakable. Export growth is down sharply, turning negative vis-à-vis the eurozone’s periphery. Import growth, a sign of future exports, has also fallen.
Similarly, Chinese residential investment and commercial real-estate activity are slowing sharply as home prices start to fall. Infrastructure investment is down as well, with many high-speed railway projects on hold and local governments and special-purpose vehicles struggling to obtain financing amid tightening credit conditions and lower revenues from land sales.
Elsewhere in Asia, Singapore’s economy shrank for the second time in three quarters at the end of 2011. India’s government predicts 6.9 percent annual GDP growth in 2012, which would be the lowest rate since 2009. Taiwan’s economy fell into a technical recession in the fourth quarter of 2011. South Korea’s economy grew at a mere 0.4 percnet in the same period—the slowest pace in two years—while Japan’s GDP contracted at a larger-than-expected 2.3 percent, as the yen’s strength weighed down exports.
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