The gloom hanging over Wayne Swan’s Budget forecasts: Maley

Wayne Swan will be hoping that local markets continue to follow the Chinese lead, rather than casting a nervous eye over to Europe and the United States, as he tries to deflect criticism that his resource super profits tax was to blame for last week’s sell-off in the Australian dollar and resources stocks.

Chinese investors were heartened yesterday by signs that Beijing’s moves to crack down on property market speculation would be less severe than they had feared. Chinese shares rose by 3.5%, their biggest single-day surge in more than seven months. The more optimistic mood infected our local resource stocks, with both BHP Billiton and Rio Tinto posting solid gains.

But this upbeat mood looks likely to be tested by the souring mood in Europe and the United States, which has seen the euro come under renewed selling pressure. The Spanish government rescue of a small Spanish savings bank drew attention to the fragile state of the Spanish banking system, which is groaning under the weight of problem loans in the property and construction sectors.

These worries then spilled over into a more general anxiety about the fractured state of the European financial system. Banks are increasingly distrustful of other banks’ credit exposures to Portugal, Greece and Spain, and this has made them reluctant to lend to each other, even on a short-term basis. This has pushed banks’ borrowing costs higher, with the three month US dollar Libor rate pushing above 0.5% for the first time since July.

Goldman Sachs’ chief European economist, Erik Nielsen, argues there is now a battle taking place between the real economy – which is gaining strength, even though it remains still fragile – and the financial markets.

As a result, there is a risk that dysfunctional financial markets may strangle the real economic recovery that is underway. “My best guess would be that the real economy has another 3-6 months to convince financial markets that fundamentals are indeed improving before continued frozen credit channels would begin to sink the real sector back into recession,” he wrote in a recent note.

But last week’s turmoil in global financial markets has prompted others to take a much bleaker outlook.

Chief strategist for RBS, Bob Janjuah, argues that forecasts for global growth are overstated. Although most people are expecting global growth of 4.5% this year, he believes that growth (on an annualised basis) will dip back to 2.5% as the effect of various government stimulus packages start to wane.

In addition, policy makers are tightening policy – fiscal, monetary and regulatory – in response to market and taxpayer revulsion with government recklessness.

Europe, he says, “has signed off from the growth path and is now firmly placing itself in the Japan-style multi-decade deflation/despair path”.

At present, he says, wealth is being destroyed in Northern Europe as it is sent to bailout unviable countries in the south and this “grotesque” misallocation of capital is having a disastrous effect on European growth. A better alternative would be to restructure Greece’s debt immediately.

Janjuah argues that the test for Europe will come in about four months’ time, when it becomes clear that Greece is missing its budget austerity targets, He argues that it is absolutely incorrect to think the euro and the eurozone will fail if the weakest link is allowed to fail. Instead, he says, the euro will fail if policy is “dictated by the weakest link (Greece) rather than the strongest link (Germany)”.

And he is extremely bearish on the outlook for global share markets. Janjuah is predicting a sharp fall in global share markets – with either a small bounce this week, followed by another big selloff, or, alternatively, another short period of weakness, followed by a month or so of stability, before a major decline.

Regardless of which pattern the market follows, he argues that “the overall trend for the rest of 2010 will be weaker with respect to growth and risk assets/markets, and higher with respect to volatility.”

Now that’s precisely the market outlook Wayne Swan did not have in mind when he signed off on his latest budget.

This article first appeared on Business Spectator.