By Marcus Svedberg, Chief Economist
The global economy is recovering and the risks have decreased, but it remains a fragile recovery – especially in Europe. In Eastern Europe, policies rather than economics exacerbate the swings in global risk appetite. Going forward, I believe the market will continue to focus more on corporate news and major macro surprises.
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Our prediction of a gradual normalisation has thus far proven correct. Growth forecasts have not changed much lately, and consensus believes in a modest economic recovery this year. There are still lots of issues, but they tend to matter less for financial markets. A useful illustration is that the unfortunate outcome of the Italian elections, combined with the start of the sequestering in the US, only caused a small and short-lived correction in the markets the first week of March. Similarly, the crisis in Cyprus only caused a marginal sell-off a few weeks later.
A lot of things can still go wrong, but the worst case scenarios remain distant. The main short-term risks are related to policy complacency in Europe and gridlock in the US, as well as fears of an earlier-than-expected withdrawal of the extraordinary accommodative monetary policies in the US.
The Euro zone remains a cause for concern, and growth has been revised down somewhat, making it difficult to reach the ambitious budget targets. The south is still struggling, illustrated by the financial crisis in Cyprus and political crisis in Italy, while there is a notable difference in dynamics at the core. There is also an escalating crisis fatigue in the north and south, combined with growing frustration within the troika.
The weak economy in the Euro zone continues to weigh on the most integrated economies in Central and Southeastern Europe, which underscores the divergent macro situation.
The economic and political situation in Eastern Europe remains highly divergent. The main positives are Turkey and the Baltic States. Turkey has managed to land the economy softly, thereby bringing down inflation and the current account deficit. The Baltic States have continued to grow faster than expected, supported by strong domestic demand. The political situation in both Turkey and the Baltics remains relatively calm and quite uneventful.
Russia and the other CIS countries are neutral or slightly negative from a macro perspective. Growth slowed more than expected to 1.6% in y-o-y terms in Russia in January, while inflation rose to an 18-month high of 7.3%. There is, however, a widespread belief that growth will start to pick up and inflation will ease in the near future. Oil prices remain supportive and the government is delivering equal doses of positive (anticorruption, privatisation, deals with China) and negative (utility tariff caps, anti-US policies, legal repression) news.
The situation in Ukraine has neither improved nor deteriorated materially lately, but remains bad. Growth and inflation were close to zero last year and the currency remains under pressure. Kyiv will soon have to choose between Russia (customs union) and the IMF (standby agreement). Each choice carries an opportunity cost for the regime, but an IMF program seems most likely at this point. Kazakhstan continues to do relatively well from a strict macro perspective, but is surprising on the downside from a policy perspective (reversal of pension reform and no major positives).
The situation in Central and Southeastern Europe remains difficult from an economic and political perspective. Growth is either low (SEE, Czech, Hungary) or decelerating (Poland, Slovakia). Inflation has fallen to new lows and rates have been cut, which should help to reignite growth, although it is unlikely to be anything but a modest recovery as long as the Euro zone is not growing. The political situation has deteriorated in Hungary (the change of central bank governor) and throughout most of the Balkans (government crises).
Most stock markets in the region rallied in January and corrected in February, before moving in opposite directions in March. Changes in global risk appetite continue to set the overall direction, but domestic developments tend to exacerbate the trends. One example is that Bulgaria was the best market in Eastern Europe in January and the worst in February, after the government collapsed.
Another is that the Slovenian market corrected when the government coalition disintegrated and rebounded after a new prime minister designate was appointed. Croatia is the best market year-to-date, as the market is pricing in the forthcoming EU accession. In Hungary, stocks corrected and the currency depreciated, as the market priced in the change of central bank governor. Turkey is trading within a range, but is impacted by rating news (negative in January, positive in March).
So, macro still matters, but it tends to be more about politics and policies than economics right now. But it is encouraging that corporate news seems to matter more and more. At the end of the day, the market will continue to react to surprises, which brings us to the outlook for the coming months.
Corporate news is likely to play an increasingly important role for markets going forward, in line with our normalisation hypothesis. Below are some potential surprises from a macro perspective. The Russian economy could start to look better in the coming months, as growth should pick up and inflation ease. But this is unlikely to excite investors as the recovery will be moderate and is broadly expected. The main risk for Russia is continued indifference from foreign investors, which can only be changed by serious reforms and/or a change in policy-makers, although something may well happen on both fronts. On the reform side, the nascent anti-corruption drive could develop into something positive and more widely appreciated.
The new central bank governor, the first woman in the role for a G8 country, will assume office this summer and may start to cut rates. There has also been renewed speculation about a Medvedev departure, but that is probably still premature, although it would be positive if he was to be replaced by Kudrin and neutral/negative if it were anyone else. More US-bashing and legal repression (against opposition and foreign investors) would reinforce the negative bias against Russia.
Turkey will struggle to surprise on the upside unless it gets a second credit rating upgrade. If growth picks up too much, the central bank will put on the brakes in order to prevent the imbalances from growing too large again. There are, on the other hand, no major risks in the short term apart from the known domestic and regional geopolitical issues. There was, however, progress on both fronts in March, as both the PKK and Israel sought to normalise relations with Turkey. Poland should not be surprising on the downside in macro terms for much longer. Most forecasters have been busy revising down
Polish growth and may have overshot, giving Poland scope to surprise on the upside, especially if Germany were to recover faster than expected. Recent macro data suggests that a recovery is distant in Hungary and it is hard to find any positive triggers other than that everyone eventually growing tired of disliking the country!
The Baltics are likely to remain in a positive, albeit dim, light, and there will be continued focus on Latvian Euro zone accession. The Baltic economies will slow down, but it is unlikely to come as a negative surprise. Ukraine should benefit if/when it gets the IMF deal, even though it has been talked about for a long time and could be accompanied by a small devaluation. Croatian EU accession is a known positive, but can nonetheless create some positive buzz.
There is a risk for more political uncertainty in Slovenia and Bulgaria, as the new governments have to consolidate power, which could prove difficult. Slovenia is likely to hesitate as long as possible but would benefit from a Euro zone bailout program. There is a risk for a political crisis in Serbia, as the prime minister is under pressure and there are strains within the ruling coalition.
Finally, the political situation in Georgia remains tense, but a successful outcome of the negotiations with Russia about resuming commercial relations (including wine exports) would probably have a significant and positive impact on sentiment.
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