At the beginning of the year, expectations for higher global growth in 2011 were high.
Now, a string of unexpected events, like unrest in the Middle East and a devastating earthquake and tsunami in Japan, has cast a shadow over some of that optimism. I
n the United States, the housing market still looks weak and unemployment remains high. Add higher gas prices to the mix, and the outlook for global growth looks less rosy.
[In Pictures: 7 Problems That Could Derail the Economy.]
“The story really is how complex and interconnected the world economy is,” says Jeffrey Cleveland, senior economist at money management firm Payden & Rygel. Here is a more complete list of events that could hinder the global economic recovery:
Rising commodity prices. Rising oil prices are on the minds of many consumers these days. The national average price of regular unleaded gasoline is $3.58, up 23 cents from a month ago, and 78 cents from a year ago as of March 29, according to AAA. Economists say gas prices are rising for two reasons: supply concerns in the Middle East and higher global economic growth expectations. Oil currently trades above $100 per barrel. Most economists say that once it reaches about $120, many consumers begin to change their driving habits. “But the key is it has to be a spike, and it needs to be sustained,” Cleveland says.
Oil isn’t the only commodity that’s heading higher. In many emerging markets like China, India, and Brazil, soaring food prices have forced leaders to raise interest rates to quell inflationary pressures. Rising commodity prices also affect companies’ bottom lines. “The biggest risk right now to the markets would be the compression in profit margins,” says Brett Gallagher, deputy chief investment officer for Artio Global Investors. “Costs are rising faster than companies’ abilities to pass those along.” He’s concerned that analysts haven’t included higher commodity prices into their earnings forecasts.
Declining consumer sentiment. This month, the Thomson Reuters/University of Michigan consumer sentiment index fell 10 points to 67.5, its lowest level since November 2009. In a recent note, Theresa Chen, analyst at Barclays Capital, said: “We believe this is largely owed to increasing commodity prices, which puts pressure on household income and personal consumption.”
Historically, consumer spending makes up about 70 per cent of economic activity in the United States, and it has played a significant role in the recovery so far. “Consumer spending was a big part of that success story in the fourth quarter of 2010,” Cleveland says. “Anything that derails that could be a problem.”
The end of QE2. The Federal Reserve’s $600 billion bond-buying program, commonly known as the second round of quantitative easing, or QE2, is set to expire in June. Once a buyer as big as the Fed exits the market, economists say they’re uncertain who’s going to step in to fill that gap. Before QE2, the Fed only purchased about 10 per cent of the total treasuries in circulation, while private domestic purchasers bought about 40 per cent and foreigners purchased the other half, says Madeline Schnapp, director of macroeconomic research at TrimTabs Investment Research. Now, about 70 per cent of all purchases are made by the Fed, and 30 per cent come from foreigners. That’s a huge gap to fill, Schnapp says. She’s worried that if no new domestic buyers emerge, interest rates could rise sharply. As the end of QE2 nears, she says, the Fed will be more clear about whether it will pursue another round of quantitative easing after June. “The market will begin to give you a hint about how it likes that decision probably about six weeks before the end of QE2,” she says.
Housing. A dramatic rise in interest rates could have ramifications for other parts of the economy, including the mortgage industry. The 30-year fixed mortgage rate currently stands at an historically low rate of about 5.1 per cent, according to HSH.com, a publisher of mortgage and consumer loan information. Typically, lower interest rates spark more buying in the housing market, but that hasn’t been the case this time around. “The combination of difficult-to-obtain financing, the very weak employment market, and a general sense of unease about how strong this recovery is coupled with home prices declining means there’s very little incentive to rush out and go do something now,” says Keith Gumbinger of HSH.com. In fact, last week new home sales plunged 16.9 per cent to a record-low annual pace of 250,000 in February. The Standard & Poor’s/Case-Shiller Home Price Index for January also showed that home prices fell for a sixth consecutive month. With such low demand, Gumbinger says a spike in interest rates could make an already bad situation worse. “A 6 per cent interest rate in this market, or above 6 per cent for a time, would be devastating,” he says.
Unemployment. The unemployment rate still remains high at 8.9 per cent. In February, the economy added 192,00 jobs, most of which were private sector jobs, which is encouraging news. Friday’s highly anticipated jobs report could potentially bring better news. TrimTabs reported Wednesday that the economy created 293,000 new jobs in March. But the latest concern has to do with state and local governments. Many states are facing huge budget shortfalls, and politicians are calling for cuts. Employees of state and local governments (think teachers and firefighters) make up about 15 per cent of the country’s total employment, Cleveland says. “We’ve seen state and local governments shedding jobs since 2008, and I expect that to continue as they go through budget cuts,” he says.
Sovereign debt worries in Europe. Portugal looks to be the next shoe to drop in the European debt crisis. Greece and Ireland have already taken bailouts from the European Union and the IMF, and economists say it’s only a matter of time before the Portuguese government, which recently collapsed, will be forced to accept a bailout of its own. Portugal, like Greece and Ireland, is seen as a small economic player in the overall scheme of things. Economists say the real concern is that the crisis spreads to other areas of Europe. If a larger country like Spain, which recently had its debt downgraded by Moody’s, was forced to take bailouts, the impact could be felt throughout the entire European Union. (Spain is the world’s 12th largest economy.) “Spain is the Big Kahuna,” Cleveland says.
Japan fallout. The most obvious lingering question in Japan is what will happen with the damaged reactors at the Fukushima nuclear power plant. Otherwise, the most pressing long-term issue in Japan is its debt problems. The country’s public debt-to-GDP ratio clocks in at 225 per cent—more than three times as high as that of the United States. “We’ve been long worried about the amount of debt that the Japanese government has,” Gallagher says. “They’re going to have to borrow to rebuild, so it just compounds the longer term issue.”