The economic data from advanced economies remain solid as GDP reports covering the final quarter of 2013 were published in the US and UK last week.
The uptrend in leading indicators of activity has continued in January, including in the eurozone.
The focus for financial markets, though, has become the sharp sell-off in emerging markets, which is having a profound impact all around. Safe haven currencies such as the yen and Swiss franc are very much in demand, stock markets have turned volatile and are moving lower, while bond markets are rallying, including at the long-end, despite favourable economic data.
Large imbalances are evident in many emerging economies but the problems are not uniform. They range from political problems to currency issues to external imbalances. However, the catalyst for the crisis is external, in the form of tighter US monetary conditions as the Federal Reserve scales back quantitative easing.
This is triggering an unwinding of capital flows, with funds moving back out of emerging markets and into safe investments like government bonds. There are also concerns about the slowdown in the Chinese economy, and whether a soft landing can be achieved by China as it moves to lower but more balanced growth.
Emerging currencies and financial markets have been under severe pressure in the past week. Some central banks have hiked interest rates to try and stabilise their exchange rates. As in the past, these countries would be better advised to let their exchange rates adjust.
Emerging economies now account for close to 40% of world GDP, compared to less than 20% in the mid-1990s. China is the world’s second largest economy. Hence, the sell-off in em-erging markets and weakening of their economies is seen as the main risk to the recovery under way in advanced economies.
Financial markets were somewhat surprised that the Federal Reserve made no reference to the problems in emerging markets when it announced a further tapering of its quantitative easing programme last week. Instead, it only focused on the strengthening recovery in the US economy.
The consensus view, though, is that the recoveries in developed economies will be able to withstand the troubles besetting emerging economies, as happened in the 1990s. The expectation is that long-term stress in emerging economies will be limited to just a few countries with serious imbalances, in particular large current account deficits.
The main central banks still indicate that interest rates can remain at their current, historically low, levels for an extended period of time, despite the strengthening of economic activity.
Thus, monetary policy will remain loose in all the major economies in 2014.
Commodity prices have also weakened in response to the slowdown in emerging economies. This has seen inflation fall in advanced economies, which brings a twin benefit. First, it boosts real spending power in these economies and consumer spending has picked up. Second, it gives encouragement to central banks to leave interest rates lower for longer.
Many analysts also view the recent fall in the major stock markets as a healthy correction after the very large gains made in 2013. The Nikkei and Dow Jones indices are down by 10% and 5% to date in 2014, but follow gains of 57% and 27% made last year.
Overall, unless it develops into a full-blown crisis in emerging economies, the recent turbulence on the markets should not derail the recoveries in advanced economies. China remains key, but has large external reserves, a big current account surplus, and can alter policy to help manage its way through any difficulties.
Oliver Mangan,chief economist, AIB
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