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Global Markets Weekly - 8th June 2009

• Data suggested a possible return to growth in the third quarter for many economies.
  Lead indicators of growth released last week continued to show improvements. In many regions, the widely followed purchasing managers’ indices (PMIs) now point towards economic expansion – albeit at very low levels – in the second half of the year. These indicators are consistent with our economic forecast at the end of last year that expansionary government policy would produce weak but positive growth by the third quarter of 2009 in most developed countries but that an actual recovery – with growth returning to around trend levels – would not happen until 2010.
• This brighter outlook has driven the equity rally, but balance-sheet constraints remain.
  Recent data releases have surprised on the upside, encouraging a rally in riskier assets, such as equities and credit. Yet this has been more a reflection of the abnormally pessimistic growth outlook engendered by the failure of Lehman Brothers than a return to a genuinely upbeat view. Households, companies and increasingly governments still face the stringent balance-sheet constraints and weak income outlooks of a year ago. In the meantime, the extreme market stress since the Lehman collapse has been and now gone.
• The dollar has suffered from this increase in risk appetite...
  This return to a 2008-style normality has translated into the recent weakness of the US dollar. Amid extreme risk aversion early this year, investors were keen to buy the safest, most liquid securities – typically US Treasuries. As risk appetite has returned, therefore, bond yields have picked up, and the dollar has weakened.
• ...more than from concerns about fiscal sustainability.
  However, recent dollar weakness has only reversed the gains the currency made in the first quarter, when equity markets were weak. So yield and currency movements since March are a symptom of the increased appetite for risk, not a risk-aversion-motivated run on the dollar. Sterling’s strength against the dollar – it’s now up 17% from its March 2009 low – confirms this conclusion. Capital flows dominated by concerns about fiscal sustainability would almost certainly affect the pound more than the dollar.
• It's a different story in Latvia...
  In some countries, however, funding concerns are the most important driver of interest rate and currency movements. Wednesday’s failed bond auction by the Latvian government has placed considerable pressure on its currency peg with the euro. A chart of the yield of 10-year Latvian government bonds shows that, despite the rally in many risk assets since March, some regions remain stuck in the immediately post-Lehman world.
• ...which is suffering from high external debt, like many other emerging economies.
  Because of the high level of external debt it accumulated before 2007, investors are no longer willing to lend to the Latvian government, or at least not at terms the Latvian government considers acceptable. In this regard, Latvia is an extreme example of the balancesheet constraints evident in many other countries which are likely to limit the pace of economic recovery.
• US consumers are rapidly rebuilding their savings, amid rising unemployment...
  Central to the current balance-sheet recession is the position of the US household sector. Data out last week showed US households' net savings rate rising rapidly, to 5.7%. The two main drivers of savings, household wealth (dominated by house prices) and unemployment, are likely to keep falling until at least the end of the year. In May, US payrolls fell 345,000 – a slower pace of decline but still enough to push the unemployment rate up to 9.4%.
• ...which is likely to restrain the pace of recovery.
  Aided by government policy, markets and economic sentiment have now recovered to more normal levels. As the payroll numbers show, however, generating a similar V-shaped recovery in the balance-sheet-constrained real economy is likely to prove harder.

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