Last autumn, financial markets feared a double-dip recession in the US, a hard landing in China's economy and a collapse in the euro area. None of these happened, as economic data in both the US and China proved stronger than the markets feared, and as the actions of the European Central Bank pulled the euro area back from the brink.

I did not share the fears about the US and China, but it was interesting to observe how market sentiment moved from one extreme of too much pessimism last autumn to the other of over-optimism. This helps to explain the rallies seen in the first quarter. Now, market sentiment is adjusting to somewhere in between.

This makes sense. The world economy continues to recover after the crisis, but the picture varies greatly. A fragile West contrasts with a resilient East.

Decoupling continents

Across Asia and many parts of the emerging world, economies are in much better shape. But even there, the picture varies. In China, for instance, the economy is cooling after the authorities tightened policy last year in order to squeeze inflation. Now, the focus in China is both on political change and on moving the economy to its next stage of development.

In the US, meanwhile, the good news is that the economy is continuing to grow, but the bad news is that the recovery is not particularly strong. It is steady, not spectacular. In the US, like the UK, the biggest firms appear in good shape, with healthy balance sheets, but for now, they appear reluctant to invest. There is still an overhang of debt, and it will take time for people and firms to deleverage. In addition, whereas the UK government has already taken big strides to try and reduce its deficit, in the US, many of these problems are being left until after the presidential election.

Although the outcome for the world economy will be heavily influenced by the US and China, it is developments in the euro area that continue to drive sentiment. The biggest threat facing the world economy is a collapse of one or more euro area economy.

That is why markets were so relieved by the actions of the European Central Bank (ECB). In December, the ECB provided cheap three-year money to banks that wanted to borrow. The success of that led the ECB to repeat the exercise in February. Its actions removed the immediate fear of a funding crisis for banks across continental Europe, and provided valuable time for the euro area to address its problems.

Changes afoot

Recent months have highlighted three types of adjustment, none of which is particularly popular. First, if the economies on the periphery were not in the euro area, they would now be seeing major currency devaluations. But because they are in the euro, they are having to endure ‘internal devaluations’ instead, which are squeezing their economies very hard. The result is recession and rising unemployment.

It is difficult for the markets to know which of these economies is the most important to focus on. Is it Greece, which may need further external help as its recession deepens? Is it Ireland, which has done all that has been asked of it but has slipped back into recession? Or is it Portugal, which some fear may be the next in trouble after Greece? Or is it Italy, the biggest peripheral economy, where an unelected government is now pushing through cuts demanded by Germany (among others)? Or is it Spain, where the government was elected only last autumn on a mandate of austerity but is already running into trouble as youth unemployment rises? To these one could add worries about France, where the presidential election adds to political, as well as economic uncertainty in Europe.

Yet, it is not just the periphery that is adjusting. In good economic times, the euro area worked, with money flowing from the centre to the periphery creating the booms that have since become busts. Indeed, before the crisis started, both Ireland and Spain had stronger fiscal positions than Germany. It was only during the bust that their budgets deteriorated. Now, in the bad times, the money that previously went to the periphery is attracted back to the core of the euro area. This is adding to inflation in Germany. The Germans do not like this, but there is little they can immediately do. After all, if the ECB raises interest rates to curb inflation in Germany, this will make the economic situation on the periphery worse.

The third area of adjustment is equally worrying for Germany. Because of imbalances between the economies across Europe, adjustments also have to take place via the central banks. This is not a worry if you think the euro will survive. But it starts to become a concern if there is a risk of any country leaving the system, as there is now.  Germany's central bank, the Bundesbank, has the biggest exposure to others, currently at around €550 billion and rising. No wonder there is concern in Frankfurt and Berlin.

Future uncertainty

There are several ways this could play out. The euro system has to change to survive, and this includes moving faster to a single political union, where the core provides more help to the periphery. Taxpayers in Germany and elsewhere fear this. Yet there is little doubt that Germany is one of the biggest beneficiaries of the euro, as its manufacturing base does not have to contend with an overvalued currency, as does Switzerland’s. But in return for ‘More Europe’, countries like Germany will demand greater say over the policies being implemented in Spain, Portugal and other countries. They may tolerate this to begin with, but if growth does not follow, and there is instead austerity and recession, anti-euro sentiment is likely to rise, as it has in Greece. So the remainder of this year is likely to see renewed uncertainty over the euro area, as was the case in 2011.