Multiple challenges on global economic front

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LONDON – Market risk looms just about everywhere, from Japan’s devastating earthquake to euro zone debt travails, Middle East turmoil and rising scepticism about US Treasuries.
It would normally be enough to send investors scurrying into safe havens. There have been some moves of that sort and are bound to be more. But enough of the risk is related to government bonds to make that option less attractive than normal. Cash, meanwhile, offers negligible returns.
So, equities have remained relatively resilient.
World stocks have come off highs, but are still clinging to year-to-date gains thanks primarily to the developed markets. How long this remains the case will depend on a broad swathe of unknowns, some of which may become clearer soon. First, Japan. The massive quake and tsunami that hit on Friday will have an economic impact and could enlarge the fiscal deficit. The yen also rose after an initial fall on the prospects of post-quake investment repatriation.
The disaster may also put some pressure on the Bank of Japan, which said it was cutting its two-day meeting short this week. It cannot do anything with rates per se even if it wanted to because the current target is just 0.05 percent. It has, however, promised to ensure market stability. Japan’s stock market, meanwhile, has been something of a favourite with global investors this year. The broad TOPIX index was up more than 8.5 percent for the year in mid-February before the recent pull back and Friday’s quake-related sell-off.
Analysts suggested that companies based in and around the main damage area could suffer losses on Monday but that construction firms would get a boost. Financial markets bounced back fairly quickly after the 1995 quake that devastated Kobe and caused $100 billion in damage. It is, meanwhile, getting to crunch time with the euro zone debt crisis. European leaders agreed on Saturday to strengthen the euro zone bailout fund, make its loans cheaper and lower the interest rate on funds extended to Greece. But they still have work to do to shore up the indebted periphery and convince the market that they have got to the root of their financial problems. “This is an important step in dealing with the Eurozone sovereign debt crisis, but it will prove to be only a temporary reprieve if countries do not deliver the required action on public finances, banks and boosting long-term competitiveness,” said Howard Archer at IHS Global Insight.
EU finance ministers meet in this week to work on a comprehensive package of anti-crisis measures, and it is all scheduled to be agreed at a full EU summit on March 24/25. But there remains something of a disconnect between the slow, measured pace adopted by the EU and markets’ desire to get the problem under control. Yield spreads – the gaps in borrowing costs – between Germany and debt-ridden outliers such as Greece and Portugal are blowing out again and the cost of insuring that debt is rising.
Investors are clearly expecting that Portugal will soon join Greece and Ireland in applying for a bailout. Markets were unimpressed, for example, with new spending cuts announced by Portugal on Friday to try to restore confidence. Ten-year bond yields held at euro lifetime highs. The key will be whether the EU package is deemed as too overtly a sticking plaster and not one that addresses some of the deep, underlying problems of the zone’s finances. John Stopford, head of fixed income at Investec Asset Management, said the EU would eventually come up with a series of improvements but they would just be steps in a process and “the underlying problems haven’t gone away”.The other major “event” is the U.S. Federal Reserve’s rate meeting tomorrow. It is not expected to make any changes in interest rates, but surging oil prices are deepening divisions inside the Fed over how to deal both with potential inflation and an economy that is still far from running at potential. Any sign that the “inflation” side is beginning to cause concern could have a sharp impact on U.S. government debt, which is already under some pressure. PIMCO, the world’s biggest bond fund, said on Wednesday it had dumped all of the U.S. government-related debt in its flagship Total Return fund.
The problem is that U.S. debt is offering very little yield and has the potential to sell off if either the economic recovery gathers pace or inflation takes off. “There is not much value in the vast majority of U.S. Treasuries,” said Charlie Morris, head of absolute returns at HSBC Global Asset Management. A lot will depend on the price of oil, which fell on Friday on concern that the Japanese earthquake would hit global economic sentiment, but which has otherwise driven higher on the revolts in North Africa and the Middle East.